Dominant part of India’s external debt ... 2.4.1 A comparative analysis ... FDI Foreign Direct Investment.

Report of the Committee to Review the Framework of Access to Domestic and Overseas Capital Markets

(Phase II, Part II: Foreign Currency Borrowing) (Report III)

Ministry of FinanceGovernment of India

February, 2015

Report of the Committee to Review the Framework of Access to Domestic and Overseas Capital Markets

(Phase II, Part II: Foreign Currency Borrowing) (Report III)

Ministry of FinanceGovernment of India

February, 2015

COMMITTEE TO REVIEW THE FRAMEWORK OFACCESS TO DOMESTIC ANDOVERSEAS CAPITAL MARKETS

New DelhiFebruary 24, 2015

Shri Arun JaitleyHon'ble Union Minister for Finance,Corporate Affairs, andInformation & BroadcastingGovernment of IndiaNew Delhi – 110 001

Dear Minister,

In continuation of its report in respect of Indian Depository Receipts submitted on June 9, 2014, theCommittee to review the framework of access to domestic and overseas capital markets, constitutedvide order F. No. 9/1/2013 – ECB dated January 1, 2014/January 10, 2014/February 5, 2014, herebypresents its report in respect of foreign currency borrowings to the Government of India.

Yours sincerely,

(M. S. Sahoo)Chairman

(S. Ravindran) (Ajay Shah)Member Member

(Manoj Joshi)Member

(Pratik Gupta)Member

(Sanjeev Kaushik)Member Convener

(Somasekhar Sundaresan)Member

Contents

Acronyms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i

Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.1 Constitution of the Committee 3

1.2 Scope of work 4

1.3 Process followed 5

1.4 Structure of the report 5

2 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2.1 The extant legal framework 82.1.1 Evolution of the framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82.1.2 The extant framework for ECB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92.1.3 The extant framework for hybrid instruments . . . . . . . . . . . . . . . . . . . . . 12

2.2 Description of outcomes 152.2.1 Dominant part of India’s external debt . . . . . . . . . . . . . . . . . . . . . . . . . . 152.2.2 Predominance of the automatic route . . . . . . . . . . . . . . . . . . . . . . . . . . 162.2.3 Increasing borrowing of longer maturity . . . . . . . . . . . . . . . . . . . . . . . . . 162.2.4 Dominance of non-resident foreign banks . . . . . . . . . . . . . . . . . . . . . . . 172.2.5 All-in-cost ceilings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172.2.6 Expanding end-uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

2.2.7 Broad pattern . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

2.3 Deficiencies in the extant arrangement 192.3.1 Complexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192.3.2 Prescriptive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202.3.3 Non-neutrality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222.3.4 Discretionary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232.3.5 Currency mismatch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242.3.6 Deficiencies summed up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2.4 International experience 272.4.1 A comparative analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272.4.2 Hedging facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292.4.3 Lessons from peer group countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

3 Guiding principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

3.1 Market failure 313.1.1 Sources and nature of currency exposure . . . . . . . . . . . . . . . . . . . . . . . 313.1.2 Is there a market failure? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323.1.3 Experience with unhedged foreign currency exposure . . . . . . . . . . . . 33

3.2 Interventions to regulate foreign borrowing 343.2.1 Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343.2.2 Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353.2.3 Auction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353.2.4 Other measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

3.3 Principles 363.3.1 ECB framework should be contemporary . . . . . . . . . . . . . . . . . . . . . . . . 363.3.2 Regulations should address market failure . . . . . . . . . . . . . . . . . . . . . . . 373.3.3 Regulations should be informed by analysis of systemic risk . . . . . . . . 393.3.4 Regulations should address the concern and do no more . . . . . . . . . 44

4 Issues and responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

4.1 What should be the objective of the ECB framework? 45

4.2 Who can borrow in foreign currency? 47

4.3 Who can lend in foreign currency? 48

4.4 Should the amount of ECB be regulated? 49

4.5 Should the maturity structure be regulated? 50

4.6 Should the cost of borrowing be regulated? 50

4.7 Should end-uses of ECB be regulated? 51

4.8 Should an ECB transaction require approval? 52

4.9 Should there be a special dispensation for PSUs? 52

4.10 Should there be a special dispensation for infrastructure? 53

4.11 How can systemic concerns arising from ECB be addressed? 54

4.12 What are the prerequisites for the revised framework? 554.12.1 Strengthen the currency derivatives market . . . . . . . . . . . . . . . . . . . . . . 564.12.2 Develop local currency denominated bond markets . . . . . . . . . . . . . 59

4.13 Can the revised framework be implemented right away? 60

4.14 How to deal with FCCBs? 61

5 Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

5.1 Learning 65

5.2 Principles 66

5.3 Recommendations 67

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

Articles 71

Reports 72

Laws 74

Annexure-A1: Ministry of Finance order dated Septem-ber 23, 2013 constituting the Committee . . . . . . . . . . . . . 77

Annexure-A2: Ministry of Finance order dated January01, 2014 modifying the terms and the constitution of theCommittee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Annexure-A3: Ministry of Finance order dated January10, 2014 further modifying the earlier order . . . . . . . . . . 85

Annexure-A4: Ministry of Finance order dated February5, 2014 further modifying the earlier order . . . . . . . . . . . . 89

Annexure-B: List of stakeholders who engaged with theCommittee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Acronyms

AD Authorised Dealer.ADB Asian Development Bank.ADR American Depository Receipt.AFC Asset Finance Company.

BhDR Bharat Depository Receipt.BSST countries Brazil, South Africa, South Korea, and Turkey.

CDC Commonwealth Development Corporation.CIC Core Investment Company.CMIE Centre for Monitoring Indian Economy Pvt. Ltd..CRR Cash Reserve Ratio.

DR Depository Receipt.

ECB External Commercial Borrowing.EME Emerging Market Economy.

FATF Financial Action Task Force.FCCB Foreign Currency Convertible Bond.FCEB Foreign Currency Exchangeable Bond.FDI Foreign Direct Investment.FEMA Foreign Exchange Management Act, 1999.FII Foreign Institutional Investor.FIPB Foreign Investment Promotion Board.FPI Foreign Portfolio Investor.FSLRC Financial Sector Legislative Reforms Commis-

sion.

GDP Gross Domestic Product.GDR Global Depository Receipt.

HFC Housing Finance Company.HLCECB High Level Committee on External Commercial

Borrowing.

ICSI Institute of Company Secretaries of India.IDR Indian Depository Receipt.IFC International Finance Corporation.IOF Financial Transactions Tax.IOSCO International Organization of Securities Commis-

sions.

LAF Liquidity Adjustment Facility.LIBOR London Interbank Offered Rate.LRN Loan Registration Number.

MFI Micro Finance Institution.MOF Ministry of Finance.MSF Marginal Standing Facility.MSME Micro Small and Medium Enterprise.

NBFC Non Banking Financial Company.NDF Non-Deliverable Forward.NDTL Net Demand and Time Liability.NGO Non Government Organization.NIPFP National Institute of Public Finance and Policy.

OTC Over The Counter.

PMEAC Economic Advisory Council to the Prime Minis-ter.

PSU Public Sector Undertaking.

QFI Qualified Foreign Investor.

RBI Reserve Bank of India.

SAT Securities Appellate Tribunal.SEBI Securities and Exchange Board of India.SEZ Special Economic Zone.SIDBI Small Industries Development Bank of India.SPV Special Purpose Vehicle.

Acknowledgements

Foreign currency borrowing, popularly known as External Commercial Borrowing(ECB), refers to commercial loans in foreign currency availed by persons resident inIndia from non-resident lenders. The Foreign Exchange Management Act, 1999 (FEMA)governs all transactions in foreign currency, including lending and borrowing in foreigncurrency. Government, at the advice of a High Level Committee on External Com-mercial Borrowing (HLCECB) formulates and reviews the ECB policy in consultationwith Reserve Bank of India (RBI) and announces the same through press releases orguidelines. While formulating or reviewing the policy, Government takes into accountthe macro-economic situation, the requirements of the corporate sector, the need tosupport certain end-uses, the state of external financial markets, the challenges facedin external sector management, and the experience gained so far in the administrationof the ECB policy and endeavours to provide flexibility in borrowing within prudentlimits. The policy so evolved is notified and administered by RBI through regulationsand circulars under FEMA.

Government has been liberalising the ECB policy from time to time to enable Indianfirms greater access to international capital markets. For example, it amended the policyin January 2005, June 2005, and January 2006 respectively to allow qualified NonGovernment Organizations (NGOs), Non Banking Financial Companies (NBFCs) andmulti-State co-operative societies to access ECB. It expanded the ambit of ‘infrastruc-ture’, which is a permissible end-use, in 2008 to include mining, exploration and refining,and in 2013 to include energy, communication, transport, water and sanitation, miningand social and commercial infrastructure.1 Similarly, Government has been streamliningthe procedure. It reduced layers of approval such as in-principle approval and taking onrecord of loan agreement from Government and FERA/FEMA approval and permissionto draw down from RBI. It delegated sanctioning authority to RBI over time while

1See, Reserve Bank of India, External Commercial Borrowings Policy - Liberalisation, RBI/2008-09/210 A.P. (DIR Series) Circular No. 20, Oct. 8, 2008; also see, Reserve Bank of India, ExternalCommercial Borrowings (ECB) Policy – Liberalisation of definition of Infrastructure Sector, RBI/2013-14/270 A.P. (DIR Series) Circular No. 48, Sept. 18, 2013.

vi

creating an automatic route under which a borrower can access ECB without requiringany approval from any authority. Generally, ECB allowed for a sector/end-use for thefirst time is kept under approval route for a while before being shifted to the automaticroute.

The ECB framework has been a product of its time. The basic structure remains thesame even though it is being refined continuously. In the meantime, Indian financialmarkets, and the legal and regulatory framework relating to financial markets andcorporate sector have become modern and contemporary. The policy stance towards theeconomy and capital flows has changed. A number of committees have brought in newthought and approach to regulation and design of financial markets. These developmentswarrant a fresh, comprehensive look at the framework of foreign currency borrowingto bring it in sync with the rest of the ecosystem. Many thought leaders have rightlyunderlined the need for a comprehensive review.2 The Committee thanks the Ministryof Finance (MOF) for providing an opportunity to do so.

I am grateful to each member of the Committee for putting in long hours of workand making significant contribution to the deliberation and drafting of this report:

1. Mr. G. Padmanabhan, Executive Director, RBI;2. Mr. S. Ravindran, Executive Director, Securities and Exchange Board of India

(SEBI);3. Dr. Ajay Shah, Professor, National Institute of Public Finance and Policy (NIPFP);4. Mr. P. R. Suresh, then Consultant, Economic Advisory Council to the Prime

Minister (PMEAC);5. Mr. Sunil Gupta, then Joint Secretary, Department of Revenue, MOF;6. Mr. Manoj Joshi, Joint Secretary, Department of Economic Affairs, MOF;7. Mr. Somasekhar Sundaresan, Partner, JSA;8. Mr. Pratik Gupta, Managing Director, Deutsche Bank;9. Mr. Bobby Parikh, Partner, BMR & Associates; and

10. Mr. Sanjeev Kaushik, then Director, Department of Economic Affairs, MOF.I am extremely grateful to Dr. Ila Patnaik, Principal Economic Adviser, Ministry of

Finance (then Professor, NIPFP) for supporting the Committee as a special invitee interms of research analysis and thought leadership.

I am thankful to Mr. Rabindra Kumar Das of Adani Group; Mr. Juvenil Jani ofAdani Mining Private Ltd.; Mr. Sanjay Agarwal of Bank of America; Mr. AbhishekGarg and Ms. Kaku Nakhate of Bank of America Merrill Lynch; Mr. Abhishek Agarwal,Mr. Ashok Swarup and Mr. Ashwani Khubani of Citibank; Ms. Bhavna Thakur and Mr.Jeetendra Parmani of Citigroup Global Markets India Private Ltd.; Mr. Akalpit Gupte,Mr. Ganapathy GR and Mr. Shailendra Agarwal of Deutsche Bank; Mr. Jitendra Jainand Mr. Kamalakara Rao Yechuri of GMR Group; Mr. Maneesh Malhotra of HSBC;Mr. Nehal Vora of BSE Ltd.; Mr. Hari K. of National Stock Exchange of India Ltd.; Ms.Kanchan Bhave, Mr. LS Narayanswami and Mr. Rajiv Seth of Standard Chartered; Mr.

2See, Committee on Fuller Capital Account Convertibility, Report of the Committee on Fuller CapitalAccount Convertibility, tech. rep., Reserve Bank of India, 2006; Working Group on Foreign Investment,Report of the Working Group on Foreign Investment, tech. rep., Department of Economic Affairs, Ministryof Finance, July 30, 2010; Committee on Financial Sector Reforms, A Hundred Small Steps, Report ofthe Committee on Financial Sector Reforms, tech. rep., Planning Commission of India, Sept. 12, 2008;and G. Padmanabhan, Administering FEMA - Evolving Challenges, tech. rep., Inaugural address at theAuthorised Dealers’ Conference at Agra on November 30, 2013, 2013.

vii

Manu J. Vettickan and Ms. Tamanna Sinha of the Ministry of Finance; Mr. R. N. Karof RBI; and Mr. Anjan Patel, Mr. Pranav Variava and Mr. V. S. Sundaresan of SEBI,for engaging with the Committee and sharing their experiences, concerns, thoughts andperspectives.

The Secretariat for the Committee, the NIPFP Macro/Finance Group, deliveredoutstanding research support as it has been doing for numerous other Governmentprojects. Mr. Pratik Datta, the leader of this team, put in tireless efforts to prepare thefirst draft of the report and brought in significant insights into the issues. Dr. RadhikaPandey and Mr. Shekhar Harikumar of the team brought on the table their perspectiveson the complex issues for consideration of the Committee and provided research support.Mr. Mehtab Hans, Ms. Sanhita Sapatnekar and Ms. Apoorva Gupta assisted in reviewingthe report. Ms. Neena Jacob of NIPFP managed the process smoothly and flawlessly.

I acknowledge the support from SEBI and NIPFP for making their facilities availableto the Committee for holding extensive meetings and extending warm hospitality.

February 24, 2015 M. S. Sahoo

Executive Summary

Firms seek the lowest possible cost of capital for financing projects. When capital isavailable at lower cost, a larger set of projects become financially viable, and greaterinvestment takes place. The policy should, therefore, aim at making capital available tofirms at the lowest possible cost. Just as trade reforms has given Indian firms the abilityto buy the cheapest goods available globally, financial reforms should give Indian firmsthe ability to obtain the cheapest capital available on a global scale.

Every firm takes on various risks in the course of its business activities, and some ofthese risks generate losses. Idiosyncratic losses by some firms, and consequent failureof some firms, are of no concern to policy makers. However, when a firm undertakesforeign currency borrowing, its balance sheet is exposed to exchange rate fluctuations. Ifnumerous firms, who undertake foreign currency borrowing, do not hedge their currencyexposure, there is a possibility of correlated failure of these firms if there is a largeexchange rate movement. The negative impact of this movement on their balance sheetscould then hamper investment and the country’s Gross Domestic Product. This imposesnegative externalities upon the citizenry which constitutes a market failure.

The firms that borrow in foreign currency may not hedge their risks from currencyexposure fully or may even undertake excessive borrowing / risks. They do it generallyfor two main reasons. First, the firms may not be able to hedge their currency exposurebecause the onshore derivatives market is shallow and illiquid, and the firms do not haveaccess to the overseas derivatives market. Second, a managed / pegged exchange rategives an implicit guarantee that there would not be large fluctuations in exchange rates.This emboldens many firms to borrow more and to leave their foreign currency exposureunhedged. They free ride on the costs paid by the economy at large in pursuit of managedexchange rate policy. The Committee notes that this carries two kinds of problems,namely, (a) the problem of political economy, where the firms lobby in favour ofperpetuation of low volatility of the exchange rate; and (b) when the inevitable exchangerate adjustment ultimately takes place, many firms may suffer losses simultaneously.

The Committee notes that the extant ECB policy requires hedging for certain cate-gories of borrowing. It is of the firm view that the possibility of market failure arising

1

from ECB can be ameliorated by building on the existing strategy, that is, requiringfirms borrowing in foreign currency to hedge their exchange risk exposure. There canbe two kinds of hedges: natural hedges or hedging using financial derivatives. Naturalhedges arise when firms sell more tradeables than they consume. This generates thenet economic exposure of an exporter. The firms may use financial derivatives such ascurrency futures, currency options, etc. to hedge their currency exposure. The mainrecommendation of this report is that Indian firms should be able to borrow abroad,through foreign currency debt, while being subject to a capital control, which requiresthem to substantially hedge their foreign currency exposure, whether through financialderivatives or natural hedges.

The Committee is conscious of the fact that hedging involves cost and given thestate of the onshore currency derivatives market, the cost of hedging may make foreigncurrency debt unattractive. The Committee, therefore, recommends that measures betaken to develop a liquid and deep onshore derivatives market. Keeping the availability ofeffective facility for borrowers to hedge their currency exposures onshore, and financialneeds of the firms and of the economy, the authorities should specify and modify thehedge ratio (percentage of currency exposure to be hedged). However, they must ensurethat this ratio is uniform across sectors or borrowers.

There is a systemic concern arising from volatility in global risk tolerance which maycreate huge fluctuations in ECB flows unrelated to fundamentals. This concern requiresmeasures to moderate ECB flows. The second recommendation of the Committee,therefore, is that the authorities may modify the required hedge ratio in response tochanges in global conditions, whenever required.

At present, there is an array of other interventions into the process of foreign currencyborrowing. Most of these interventions were brought in to meet the specific needs of thehour and have outlived their utility. None of them seems to be addressing any identifiedmarket failure today. The Committee, therefore, recommends a complete removal ofthese interventions. It does not recommend interventions in the form of taxation orauction as advocated by some experts as these could reduce the volume of transactionsbut not address the identified market failure.

Mr. G. Padmanabhan and Mr. S. Ravindran, members of the Committee do not fullyconcur with some of the recommendations and observations in the report. These havebeen recorded in the relevant paragraphs in the report.

This is the third report (Report III) written by this Committee, the previous two beingon American Depository Receipt (ADR)/Global Depository Receipt (GDR) issuance(Report I) and on Indian Depository Receipt (IDR)/Bharat Depository Receipt (BhDR)issuance (Report II). The first of these reports has been substantially implementedthrough the new Depository Receipts Scheme, 2014. The union budget for 2014-15 hasproposed to completely revamp the IDR and introduce a much more liberal and ambitiousBhDR, which has been the recommendation of the second report. In all the three reports,the consistent intellectual strategy has been to identify market failures, if any, and addressthem, and to remove all other aspects of capital controls or administrative overhead. Thisyields a substantial reduction in the cost of doing business in India and improves India’sengagement with financial globalisation. The resulting frameworks are conceptuallyclear, involve reduced legal risk and reduce the need for private firms to interact with theauthorities and thereby improve the ease of doing business.

1 — Introduction

1.1 Constitution of the CommitteeMOF constituted a Committee, vide its Office Order dated September 23, 2013 (Annexure-A1), to comprehensively review the Foreign Currency Convertible Bonds and OrdinaryShares (Through Deposit Receipt Mechanism) Scheme, 1993. Accordingly, on Novem-ber 26, 2013, the Committee submitted to the MOF its report on Depository Receipts(DRs) along with a draft scheme in replacement of the extant scheme.3 This report ishereinafter referred to as the Report I. The draft scheme (except the portion relating totax) has been notified by MOF through a notification dated October 21, 2014.4 RBI hasalso amended FEMA 20 and inserted Schedule 10, pursuant to the recommendations ofthe Committee.5

Subsequently, vide Office Orders dated January 1, 2014 (Annexure-A2), January 10,2014 (Annexure-A3) and February 5, 2014 (Annexure-A4), the MOF reconstituted theCommittee as under:

1. Mr. M. S. Sahoo, then Secretary, Institute of Company Secretaries of India (ICSI);2. Mr. G. Padmanabhan, Executive Director, RBI;3. Mr. S. Ravindran, Executive Director, SEBI;4. Dr. Ajay Shah, Professor, NIPFP;5. Mr. P. R. Suresh, then Consultant, PMEAC;6. Mr. Sunil Gupta, then Joint Secretary, Department of Revenue, MOF (since left

Government and did not participate in the process after some time);7. Mr. Manoj Joshi, Joint Secretary, Department of Economic Affairs, MOF;8. Mr. Somasekhar Sundaresan, Partner, JSA;

3See, Ministry of Finance, Report of the committee to review the FCCBs and Ordinary Shares (ThroughDepository Receipt Mechanism) Scheme, 1993, tech. rep., Ministry of Finance, Nov. 26, 2013.

4See, Department of Economic Affairs, Ministry of Finance, Depository Receipts Scheme, 2014,Oct. 21, 2014.

5See, Reserve Bank of India, Foreign Exchange Management (Transfer or issue of security by aperson resident outside India) (Seventeenth Amendment) Regulations, 2014, Notification No. FEMA330/2014-RB dated, Dec. 15, 2014.

4 Introduction

9. Mr. Pratik Gupta, Managing Director, Deutsche Bank;10. Mr. Bobby Parikh, Partner, BMR & Associates; and11. Mr. Sanjeev Kaushik, then Director, Department of Economic Affairs, MOF.

These orders mandate the Committee to review the entire framework of access todomestic and overseas capital markets and related aspects. These include the frameworksrelating to:

• Indian depository receipts (IDRs);• ECB and Foreign Currency Convertible Bonds (FCCBs);• Direct listing of Indian companies abroad;• Dual listing of Indian companies;• Residence-based taxation vis-a-vis source based taxation; and• Relationship between authorities in India and those in foreign jurisdictions.Pursuant to the above, the Committee undertook a review of the framework relating

to IDRs and submitted its report on the same along with the draft BhDR Guidelines tothe MOF on June 9, 2014.6 This report is hereinafter referred to as the Report II. Thisreport has been released by Government seeking comments from the public.7 On July10, 2014, the Finance Minister in his budget speech has proposed that Government will‘completely revamp the IDR and introduce a much more liberal and ambitious BhDR’.8

In continuation of the above, the Committee worked on ECB, which is the subjectmatter of this report. This report is hereinafter referred to as Report III.

1.2 Scope of workThe Committee has a very wide ranging terms of reference. While deliberating on these,its strategy has been to refocus the interventions of the State upon addressing marketfailures. This implies removing existing interventions that cannot be justified in terms ofmarket failures. The second element of the strategy has been the reinforcement of ruleof law into the working of capital controls in India.

The 1993 Scheme was one of the early moves to open up the Indian capital account.It allowed Indian issuers to raise capital from international capital markets through theDR route. The early motivation was to give foreign investors a mechanism to connectwith Indian companies without dealing with the problems of the Indian equity market.The reforms since 1993 have yielded a world class equities market in India. This changedthe purpose of DRs, from addressing the weaknesses of the domestic equity market toalleviating home bias faced by most Indian firms. The Report I brought in contemporarythinking in financial economic policy in India into this field. The Committee drafted anew scheme for DRs to replace the 1993 Scheme.9

Just as DR issuance connects foreign investors to Indian companies, IDR issuanceconnects foreign companies to Indian investors. While IDRs found place in the statute in2000, the development of the enabling framework took quite some time. Till date only

6See, Ministry of Finance, Report of the committee to review the framework of access to domestic andoverseas capital markets, tech. rep., Ministry of Finance, June 9, 2014.

7See, Press Information Bureau, Report of the Committee to Review the Framework of Access toDomestic and Overseas Capital Markets (Phase II, Part I: Indian Depository Receipts).

8See, Ministry of Finance, Budget Speech by Hon’ble Finance Minister, tech. rep., July 10, 2014.9This scheme was notified by the Ministry of Finance on October 21, 2014, with necessary modifica-

tions. See, DEA, Depository Receipts Scheme, 2014, see n. 4.

1.3 Process followed 5

one IDR issue has taken place. The Report II also brought in contemporary thinkingin financial economic policy in India into this field. The Committee recommendedstreamlining various regulations to address potential market failures in the IDR market.Along with the report, the Committee also submitted draft guidelines to assist theconcerned regulators in drafting the requisite regulations.

The third element of the work is in foreign currency borrowing by Indian firms,which is the subject of the instant report (Report III). The analysis of this report replicatesthe strategy of the previous two elements: bringing in contemporary thinking in financialeconomic policy in India to the question, which involves refocusing State interventionsupon market failures, reducing administrative overhead by removing interventions whichare not grounded in addressing market failures, and reinforcing the rule of law.

1.3 Process followedThe Committee had four meetings devoted to deliberations on ECB. During thesemeetings it consulted the stakeholders concerned, and delineated the relevant policyissues and deliberated extensively on the same. The deliberations of the Committee wereinformed by the research conducted by its secretariat, the NIPFP Macro/Finance Group.The research was based on relevant data collected by the NIPFP Macro/Finance Groupfrom various sources, including some of the stakeholders and RBI, and contemporarythought as reflected in recent policy decisions and committee reports. The list ofstakeholders who engaged with the Committee is at Annexure-B.

1.4 Structure of the reportThe report is structured as follows. Chapter 2 describes the design, outcome and defi-ciencies of the extant ECB framework. It also compares the extant ECB framework withthat of some of the peer countries to focus on the specific regulatory areas that need tobe redesigned. Chapter 3 attempts to understand market failures in the context of foreigncurrency borrowing and the interventions necessary to address the same. It distills thepolicy reforms strategies for foreign currency borrowing as articulated by previous expertcommittees, the economic rationale for regulating such activities and the principles thatmust guide the recommendations of the Committee in rationalising the regulations onECB. Chapter 4 focuses on the policy issues relevant to ECB and analyses them indepth, keeping in view the principles of economics, law and regulations enunciated inearlier chapters. Chapter 5 summarises the principles guiding the recommendations ofthe Committee and its recommendations based on the same.

2 — Background

Capital is a key input that shapes the competitiveness of firms. To be a low cost producerof steel in India, it is important to match the cost of capital obtained by the top steelcompanies of the world. Just as Indian steel companies have the choice of buying coal,iron ore or capital goods at the lowest cost, they must also have the choice of raisingcapital - debt or equity - abroad on competitive terms.

Firms have the option of raising capital in the form of equity or debt, locally orglobally, in domestic or foreign currency. There are limits on each mode of raisingcapital and there are reasons to prefer one option over another. For example, given thelevel of development of the bond market in India, it may not be possible to borrow hugeamounts domestically. This has, in fact, prompted firms to increasingly depend on bankcredit for debt needs. Given the stress in the banking system, there are concerns aboutthe extent to which the next wave of investment can obtain debt financing.

This calls for reforms in foreign capital inflows for debt financing. This can be donein two ways:

1. Onshore issuance of bonds denominated in rupees which are purchased by foreigninvestors operating in India. This channel places no currency exposure uponIndian persons and there is no market failure. This needs to be permitted, enabledand encouraged.

2. Overseas issuance of foreign currency denominated bonds by Indian firms. Thisinvolves certain policy concerns which is the focus of the present report.

This chapter provides the background necessary to appreciate the extant legal frame-work supporting ECB and the need for its review. It gives an overview of the regulationsgoverning this field, their outcomes and the difficulties with the present arrangement. Itthen looks at how Brazil, South Africa, South Korea, and Turkey (BSST countries) haveaddressed this through regulations. It concludes that the extant framework needs to bechanged to make it in sync with global best practices and contemporary policy thinkingin this field.

8 Background

2.1 The extant legal framework2.1.1 Evolution of the framework

From the 1950s to the early 1980s, Indian firms’ access to international capital marketswas restricted mainly to bilateral and multilateral assistance. In course of time, thesesources of finance were found inadequate and were supplemented with commercialborrowing through international capital markets. In the second half of the 1980s, thepolicy framework encouraged financial institutions and public sector undertakings toaccess the international market. With the introduction of economic reforms since thebalance of payments crisis, external assistance ceased to be an important element ofcapital inflows and private capital flows gained prominence. ECB rose significantly inthis period.10 In the following years, India pursued a regulatory approach of encouragingnon-debt creating flows and placing restrictions on debt creating flows.11 During initialyears, the MOF used to decide the ECB policy through guidelines and administer thesame.12 In course of time, the administration was fully transferred to RBI, while thepolicy is being determined by Government is consultation with RBI.

Section 6(3)(d) of the Foreign Exchange Management Act, 1999 empowers RBI toissue regulations governing any borrowing or lending in foreign exchange. Pursuant tothis provision, RBI has categorised various forms of foreign currency borrowing andissued regulations governing these categories:

1. External Commercial Borrowing: These are commercial loans in the form ofbank loans, buyers’ credit, suppliers’ credit, securitised instruments (like floatingrate notes and fixed rate bonds, non-convertible, optionally convertible or par-tially convertible preference shares) availed of from non-resident lenders with aminimum average maturity of three years. ECB is governed by FEMA 3.13

2. Foreign Currency Convertible Bonds: These are issued by an Indian companyand subscribed by non-residents. These are convertible into ordinary shares of theissuing company in any manner, either in whole, or in part. The issue of FCCBsis governed by the 1993 Scheme and the provisions of FEMA 120.14 The ECBregulations are applicable to the debt portion of FCCBs.

3. Preference shares: Preference shares of Indian companies (which may be non-convertible, optionally convertible or partially convertible) for issue of which fundshave been received on or after May 1, 2007 are considered as debt. Accordingly,these attract the ECB framework.

4. Foreign Currency Exchangeable Bonds: These are issued by an Indian com-

10See, Bhupal Singh, Corporate choice for overseas borrowings: The Indian evidence, MPRA Paper,University Library of Munich, Germany, 2007.

11This approach was advocated by the Rangarajan Committee. See, C. Rangarajan, Report of the HighLevel Committee on Balance of Payments, tech. rep., Government of India, 1993.

12See, Ministry of Finance, Government revises External Commercial Borrowings Policy, Nov. 12, 2003,URL: http://pib.nic.in/archieve/lreleng/lyr2003/rnov2003/12112003/r1211200314.html (visited on 09/12/2014).

13See, Reserve Bank of India, Foreign Exchange Management (Borrowing or lending in foreignexchange) Regulations, 2000, Notification No. FEMA 3/2000-RB dated 3rd May 2000, May 3, 2000.

14See, Department of Economic Affairs, Ministry of Finance, Issue of Foreign Currency ConvertibleBonds and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993, GSR 700(E),Nov. 12, 1993; Reserve Bank of India, Foreign Exchange Management (Transfer or issue of any foreignsecurity) Regulations, 2004, Notification No. FEMA 120/RB-2004 dated July 7, 2004, July 7, 2004.

2.1 The extant legal framework 9

pany (called the ‘issuing company’) and subscribed by non-residents. These areconvertible into equity shares of another company, called the ‘offered company’.The ‘issuing company’ is part of the promoter group of the ‘offered company’and holds the equity shares offered at the time of issuance of Foreign CurrencyExchangeable Bond (FCEB). The FCEBs are governed by the 2008 Scheme.15

The regulations governing ECB also apply to FCEBs.RBI amends and modifies regulations through notifications. It also issues circulars

to clarify the legal position on various issues. In July every year, it brings up a mastercircular explaining the updated policy position, and consolidating all the relevant notifi-cations and circulars issued by it over the course of the previous year. The latest mastercircular provides the updated policy framework as on November 25, 2014 with regard toECB.16

2.1.2 The extant framework for ECB

ECB can be accessed under the automatic route or the approval route. Under theautomatic route, no approval is needed to access ECB. Under the approval route, specificapproval from RBI is necessary. Broadly a borrowing not covered under automaticroute requires approval of RBI. Generally, ECB allowed for a sector or end-use for thefirst time is kept under the approval route before being shifted to the automatic route.Further, banks and financial institutions have relatively more restrictions on accessingECB. Borrowing, whether under the automatic or the approval route, are subject tonumerous restrictions, including restrictions on who can borrow, who can lend, the termsof the borrowing, the uses to which the borrowed amount can be put (‘end-use’), thecost of borrowing (‘all-in-cost’) and so on.17 This section describes these restrictions onautomatic and approval routes in detail. Table 2.2 provides a brief comparative overviewof the key parameters of these restrictions.

Automatic route• Eligible borrowers: Initially, only firms registered under the Companies Act, 1956,

except financial intermediaries, were allowed to borrow under this route. Overtime, the list of eligible borrowers has expanded to include certain categories ofNBFCs, NGOs, Special Economic Zones (SEZs), and Micro Finance Institutions(MFIs).18

• Recognised lenders: There are several internationally recognised lenders, suchas international banks, international capital markets, and multilateral financialinstitutions such as International Finance Corporation (IFC), Asian DevelopmentBank (ADB), and Commonwealth Development Corporation (CDC), export credit

15See, Department of Economic Affairs, Ministry of Finance, Issue of Foreign Currency ExchangeableBonds Scheme, 2008, GSR 89(E), Feb. 15, 2008.

16For the latest version, see, Reserve Bank of India, Master Circular on External Commercial Borrow-ings and Trade Credits, July 1, 2014.

17The cost of borrowing in the international capital markets is linked to the 6-month London InterbankOffered Rate (LIBOR) for the respective currencies in which the loan is raised. Referred to as the‘all-in-cost’, it includes rate of interest, other fees and expenses in foreign currency except commitmentfee, pre-payment fee, and fees payable in Indian Rupees. This is an important instrument in the hands ofthe regulator to modulate capital flows. See Part I I.(A) iv, ibid.

18See Part I(I)(A)(i), ibid.

10 Background

Table 2.1: All-in-cost ceilings over 6 month LIBOR (Basis points)

Date of RBI circulars ≥ 3 years ≤ 5 years ≥ 5 years ≤ 7 years ≥ 7 years31.01.2004 200 350 35021.05.2007 150 250 25029.05.2008 200 350 35022.09.2008 200 350 45022.10.2008 300 500 50009.12.2009 300 500 50023.11.2011 350 500 500

Source: RBI

agencies, suppliers of equipment, foreign collaborators and foreign equity holders.Overseas organisations and individuals with a certificate of due diligence fromoverseas bank adhering to host country regulations are allowed to lend under theautomatic route. Foreign equity holders are also recognised lenders under certainspecified conditions.19

• Amount: The framework specifies the maximum amount that can be borrowed byeach category of eligible borrower and for each purpose. As an example, whilethe maximum amount that can be borrowed by a firm is USD 750 million, firmsin specific sectors such as hotels, hospitals and software sector and miscellaneousservices are allowed to borrow up to USD 200 million. In some cases it is linkedto a percentage of its own funds.

• Maturity: ECB upto USD 20 million or its equivalent can be raised in a financialyear with minimum average maturity of 3 years. ECB above USD 20 million orequivalent and upto USD 750 million or its equivalent can be raised in a financialyear with a minimum average maturity of 5 years.20

• All-in-cost ceiling: The all-in-cost ceiling was reduced in May 2007 from 200basis points to 150 basis points over the six-month LIBOR for ECB of tenor ofthree to five years. For a tenor of more than five years, the cost ceiling was reducedfrom 350 basis points to 250 basis points over six-month LIBOR.21 Since then,there has been a progressive liberalisation of the spreads. Table 2.1 shows thechanges in the all-in-cost ceilings from 2004 onwards.22

• End-use restrictions: Borrowing is permitted for import of capital goods, mod-ernisation or expansion of existing production units in the real sector, includinginfrastructure, and overseas direct investment in joint ventures and wholly ownedsubsidiaries. Over time, the list of permissible activities has been expanded toenable certain categories of NBFCs to avail of ECB for on-lending and leasingto infrastructure projects. ECB is also allowed for general corporate purposes bycertain categories of eligible borrowers from direct foreign equity holders subjectto certain conditions.23 It is generally not permitted for on-lending or investmentin capital market, real estate, working capital, general corporate purpose andrepayment of existing rupee loans.

• Guarantees: Issuance of guarantee, standby letter of credit, letter of undertaking

19See Part I(I)(A)(ii), Reserve Bank of India, 2014 Master Circular, see n. 16.20See Part I(I)(A)(iii), ibid.21See, Reserve Bank of India, External Commercial Borrowings (ECB) – End-use and All-in-cost

ceilings - Revised, RBI/2006-2007/409 A. P. (DIR Series) Circular No. 60, May 21, 2007.22Also see Part I(I)(A)(iv), Reserve Bank of India, 2014 Master Circular, see n. 16.23See Part I (I)(A)(v), ibid.


or letter of comfort by banks, financial institutions and NBFCs from India relatingto ECB is not permitted.24

• Parking of ECB proceeds: If funds are borrowed for rupee expenditure, theyshould be repatriated immediately. In case of foreign currency expenditure, ECBproceeds may be retained abroad pending utilisation. When retained abroad, thefunds may be invested in prescribed assets.25

• Prepayment: Prepayment of ECB up to USD 500 million may be allowed by Au-thorised Dealer (AD) banks without prior approval of RBI, subject to compliancewith the stipulated minimum average maturity period as applicable to the loan.26

• Refinancing of an existing ECB: Borrowers are allowed to refinance their existingECB by raising a fresh ECB subject to the condition that the fresh ECB is raisedat a lower all-in-cost ceiling and the outstanding maturity of the original ECB ismaintained.27

• Procedural requirements: Borrowing firms are required to report details of loanagreements to the ADs for any amount of ECB in any category.28

Approval route

Generally, ECB beyond the amount (for example, USD 750 million by corporatesand SEZ, USD 200 million by hotel, hospital and software sector) permissible underautomatic route and ECB with maturities falling outside the limits under automatic routeare considered under approval route.

• Eligible borrowers: A variety of borrowers are permitted to access ECB under theapproval route. These include:29

– Banks and financial institutions which had participated in the textile or steelsector restructuring package;

– NBFCs undertaking ECB with a minimum average maturity of 5 years;– Housing finance companies undertaking FCCBs;– Special purpose vehicles or any other entity notified by RBI set up to finance

infrastructure companies/ projects;– Multi-state co-operative societies engaged in manufacturing activity;– Certain categories of NBFCs, SEZ developers, Small Industries Development

Bank of India (SIDBI).• Recognised lenders: The list of eligible lenders is broadly similar to the one

prescribed under the automatic route. Indirect equity holders and group companies

24See Part I(I)(A)(viii), ibid.25See Part I(I)(A)(x), ibid.26See Part I(I)(A)(xi), ibid.27See Part I(I)(A)(xii), ibid.28 This information is submitted in Form-83. See Annex I, Reserve Bank of India, External Commercial

Borrowings (ECB) – Rationalisation of Form-83, RBI/2011-12/620 A. P. (DIR Series) Circular No. 136,June 26, 2012; the AD has to certify that the borrowing company complies with the ECB regulationsand that the AD recommends the application for allotment of Loan Registration Number (LRN). Theborrower can draw-down the loan only after obtaining the LRN from RBI. In addition, borrowers arerequired to submit ECB-2 return certified by the designated AD bank on a monthly basis ensuring itreaches RBI within seven working days from the close of the month to which it relates. See Annex III,Reserve Bank of India, 2014 Master Circular, see n. 16.

29See Part I(I)(B)(i), Reserve Bank of India, 2014 Master Circular, see n. 16.

12 Background

can also lend under specified conditions.30

• Amount: Under the approval route, it is possible to borrow amounts exceedingthe amounts permissible for different categories of borrowers under the automaticroute.31

• Maturity: Under the approval route, it is possible to borrow for maturities fallingoutside the limits under the automatic route. The borrowers may avail of shortterm credit under the ECB in anticipation of it being replaced by long-term ECB.32

• All-in-cost ceilings: The all-in-cost ceilings under the approval route are similarto those under the automatic route.33

• End-use restrictions: Though broadly similar to those under automatic route, thereare several exceptions. While ECB for acquisition of a company is prohibitedunder the automatic route, it is permitted under the approval route for acquisitionby a IFC, EXIM bank, etc. Firms in the power sector are allowed to refinance rupeedenominated loans through ECB to a much greater extent than other infrastructurefirms.34 Civil aviation firms can use ECB for working capital requirements.35

• Guarantee: Issuance of guarantee, standby letter of credit, letter of undertaking orletter of comfort by banks, financial institutions and NBFCs relating to ECB isnot normally permitted. For some sectors, issuance of guarantees are consideredsubject to prudential norms.36

• Prepayment: Prepayment for amounts exceeding USD 500 million is considered.37

• Refinancing/Rescheduling of existing ECB: The existing ECB may be refinancedby raising a fresh ECB subject to the condition that the fresh ECB is raised at alower all-in-cost, the outstanding maturity of the original ECB is not reduced andthe amount of fresh ECB is beyond the eligible limit under the automatic route.Such refinance is not permitted by raising fresh ECB from overseas branches/sub-sidiaries of Indian banks.38

In addition to the regulatory framework governing firm’s borrowing, there is anaggregate soft cap on ECB which is decided by the HLCECB. The HLCECB is chairedby the Finance Secretary and has officials from RBI and MOF.

2.1.3 The extant framework for hybrid instruments

This section offers a brief overview of the extant framework for FCCBs and FCEBs.As hybrid instruments, these are subject to restrictions applicable to equities as well asdebt instruments. Further, FCCBs must conform to the Foreign Direct Investment (FDI)

30See Part I(I)(B)(ii), Reserve Bank of India, 2014 Master Circular, see n. 16.31See Part I(I)(B)(iii), ibid.32See Part I(I)(B)(v)(h), ibid.33See Part I(I)(B)(iv), ibid.34Indian companies which are in the infrastructure sector (except companies in the power sector), as

defined under the extant ECB regulations, are permitted to utilise 25% of the fresh ECB raised by themtowards refinancing of the Rupee loans availed by them from the domestic banking system, the companiesin the power sector are permitted to utilize up to 40% of the fresh ECB raised by them towards refinancingof the Rupee loans availed by them from the domestic banking system. See Part I(I)(B)(v)(f), ibid.

35See Part I(I)(B)(v)(i), ibid.36See Part I (I)(B)(x), ibid.37See Part I(I)(B)(xiii), ibid.38See Part I(I)(B)(xiv), ibid.


Table 2.2: ECB frameworkParameter Automatic Route Approval Route

Eligible Borrowers Companies, NBFCs (except financial inter-mediaries), SIDBI, NGOs, SEZs, MFIs andothers.

Includes a broader set of borrowers. How-ever, these are mostly banks and NBFCs.These are under approval route probably be-cause of their systemic importance.

Recognised Lenders Several internationally recognised lenderslike international banks, international capi-tal markets, and multilateral financial insti-tutions and foreign equity holder under cer-tain specific conditions.

Broadly similar to automatic route. Relaxednorms for borrowing from foreign equityholders.

Amount Specifies the maximum amount that can beborrowed by each category of eligible bor-rower. The maximum amount that can beraised by a corporate other than those in thehotel, hospital and software sectors is USD750 million.

It is possible to borrow amounts exceedingthe permissible amounts for different cat-egories of borrowers under the automaticroute.

Maturity Minimum average maturity of 3 years forECB up to USD 20 million in a financialyear;Minimum average maturity of 5 years forECB from USD 20 million to USD 750 mil-lion in a financial year.

Cases falling outside the purview of the ma-turity periods under the automatic route.

All-in-cost ceiling 350 basis points over 6 months LIBOR forECB with maturity of 3 to 5 years;500 basis points over 6 months LIBOR forECB with maturity beyond 5 years.

Same.

Permitted end-use Import of capital goods, modernisation orexpansion of existing production units inthe real sector, including infrastructure, andoverseas direct investment in joint venturesand wholly-owned subsidiaries.

Broader end-uses permitted including work-ing capital for civil aviation sector. Repay-ment of Rupee loans permitted for certainsectors.

Prohibited end-use On-lending or investment in capital marketsor acquiring a company (or part thereof) inIndia by a corporate;real estate;general corporate purposes with some ex-ceptions;other than the purposes specifically permit-ted.

Broadly similar.

Guarantees Guarantees by entities from India not per-mitted.

Not normally permitted unless specificallyapproved.

Prepayment Prepayment upto $ 500 million. Prepayment beyond $ 500 million.

Refinancing of existing ECB The existing ECB may be refinanced by rais-ing a fresh ECB subject to conditions.

Similar.

Hedging Holding Companies or Core InvestmentCompanies (CICs); NGOs engaged inmicro-finance; MFIs; NBFCs-IFCs; cer-tain IFCs; NBFCs-Asset Finance Compa-nys (AFCs); SIDBI.

SIDBI; Holding Companies or CICs; Devel-opers of low cost housing projects; HousingFinance Companies (HFCs).

14 Background

policy.39

Foreign Currency Convertible Bonds

Any company raising foreign funds through FCCBs must obtain permission fromMOF.40 As with all foreign currency borrowing, there are a number of restrictionsthat apply to these instruments.

The Foreign Exchange Management Act, 1999 prohibits issue or transfer of a foreignsecurity by a person resident in India unless specifically permitted by RBI.41 Accordingly,the 2014 Master Circular, FEMA 3 and FEMA 120 apply to the debt portion of theFCCBs. They permit issue of FCCBs subject to restrictions on the amount,42 maturity,43

all-in-cost ceilings,44 and hedging.

In addition, because these are hybrid instruments with equity component, additionalrestrictions apply regarding the jurisdictions in which they can be listed45 and theconversion price.46 The interest from FCCBs is subject to 10% taxation at source.47

However, conversion to equity and transfer of the FCCB abroad from one non-residentto another are not taxable.

Foreign Currency Exchangeable Bonds

FCEBs can be issued by any Indian company (‘issuing company’) eligible to raise fundsfrom Indian securities market. These instruments may be convertible into equity sharesof a listed company (‘offered company’), which is engaged in a sector eligible to receiveFDI and eligible to issue or avail of FCCB or ECB.48 Restrictions apply on maturity,49

39See, DEA, 1993 Scheme, see n. 14.40See, ibid.41See section 6(3)(a), Foreign Exchange Management Act, 1999.42The amount cannot exceed USD 750 million in a financial year through automatic route. Issue of

FCCBs beyond USD 750 million requires specific approval from RBI. See Schedule I, Reserve Bank ofIndia, FEMA 120, see n. 14.

43The maturity of these instruments cannot be more than 5 years. See, ibid.44The all-in-cost ceilings and end-use restrictions are aligned with those of ECB under FEMA 345If the company is unlisted, it can issue FCCBs only if they are listed in International Organization of

Securities Commissions (IOSCO) or Financial Action Task Force (FATF) compliant jurisdictions. BeforeOctober 11, 2013, unlisted companies were required to simultaneously list on an Indian stock exchange.See, Ministry of Finance, Issue of Foreign Currency Convertible Bonds and Ordinary Shares (ThroughDepositary Mechanism)(Amendment) Scheme, 2013, Notification No. GSR 684(E) [F.No.4/13/2012-ECB],Oct. 11, 2013.

46The conversion price of FCCBs into the underlying equity should not be less than the average of theweekly high and low of the closing prices of the related shares quoted on the stock exchange during thetwo weeks preceding the relevant date. See paragraphs 5(4)(ca) and 5(4)(e)(i), DEA, 1993 Scheme, seen. 14.

47See section 115AC, Income Tax Act, 1961.48See paragraph 3(1) and 3(2), DEA, 2008 Scheme, see n. 15.49The minimum average maturity of FCEB is five years.

2.2 Description of outcomes 15

exchange price,50 end-use,51 interest,52 and dividend payments.53 However, conversionto equity and transfer of the FCEBs abroad from one non-resident to another are nottaxable.

The subscriber to FCEBs is required to comply with the FDI policy and adhere tothe sectoral caps at the time of issuance of FCEBs. Prior approval of Foreign InvestmentPromotion Board (FIPB), wherever required under the FDI policy, should be obtained.54

The rate of interest payable on FCEB and the issue expenses incurred in foreign currencymust conform to the all-in-cost-ceilings prescribed by RBI under the ECB regulations.55

2.2 Description of outcomes2.2.1 Dominant part of India’s external debt

As may be seen from Table 2.3, commercial borrowing constitutes a significant portionof external debt. The ECB liabilities increased from USD 30.92 billion in 2001 to USD147.93 billion at the end of March 2014. As a percentage of total debt outstanding, itincreased from 16.59% in 1991 to 30.52% in 2001.56 Thereafter, it has remained steadyat the same level while there has been more than a four-fold increase in total outstandingdebt. This trend shows that ECB has emerged as a major source of financing for Indianfirms.

Table 2.3: Outstanding external debt and ECB liabilities (Amount in USD billion)

As on 31st March Total Debt External Commercial Borrowings Share of ECB in total debt (%)2001 101.32 30.92 30.522002 98.84 29.58 29.932003 104.91 28.07 26.762004 112.65 25.81 22.912005 134.00 31.60 23.582006 139.11 32.37 23.272007 172.36 48.46 28.112008 224.41 71.05 31.662009 224.49 77.86 34.682010 260.93 82.52 31.622011 317.89 108.33 34.082012 360.80 126.29 35.002013 PR 409.40 138.69 33.882014 QE 440.60 147.93 33.58

Source: India’s external debt: A status report, 2013-14, Ministry of Finance, August, 2014PR: Partially revised, QE: Quick estimates

50At the time of issuance of FCEB, the exchange price of the offered listed equity shares must not beless than the higher of the following two:

• the average of the weekly high and low of the closing prices of the shares of the offered companyquoted on the stock exchange during the six months preceding the relevant date; and

• the average of the weekly high and low of the closing prices of the shares of the offered companyquoted on a stock exchange during the two week preceding the relevant date.

See paragraph 6(2) and 6(3), DEA, 2008 Scheme, see n. 15.51The end-use of FCEB must confirm to the end-uses prescribed under the ECB policy. See paragraph

4(1), ibid.52Interest payments are subject to deduction of tax at source. See section 115AC, see n. 47.53 The dividend on the exchanged portion of the bond is subject to tax. See 115AC(1), ibid.54See paragraph 3(4), DEA, 2008 Scheme, see n. 15.55See, ibid., paragraph 6(1),56See Annex II and Annex XXII, Department of Economic Affairs, India’s External Debt Report,

tech. rep., Aug. 2014.

16 Background

Table 2.4 presents year-wise approvals, disbursements, amortisation, interest pay-ments, debt service and status of outstanding debt on account of ECB. There is an annualinflow of about USD 30 billion every year in the recent past.

Table 2.4: Details of ECB flows (Amount in USD million)

Year Approvals Gross disbursements Amortisation Interest Total debt service Debt outstanding2001 2,837 9,295 5,043 1,683 6,726 30,9222002 2,653 2,933 4,013 1,534 5,547 29,5792003 4,235 3,033 5,001 1,180 6,181 28,0742004 6,671 5,149 8,015 2,031 10,046 25,8092005 11,490 9,094 3,571 959 4,530 31,5952006 17,175 14,606 11,518 2,996 14,514 32,3712007 24,492 20,727 3,785 1,709 5,494 48,4592008 28,842 29,112 6,063 2,630 8,693 71,0512009 16,517 14,024 6,426 2,702 9,128 77,8622010 21,703 15,951 11,501 2,397 13,898 82,5182011 25,012 23,008 10,440 2,584 13,024 1,08,3282012 35,240 31,791 16,478 4,326 20,804 1,26,2882013 PR 31,670 28,563 16,355 4,990 21,345 1,38,6942014 QE 33,218 29,198 18,386 4,663 23,049 1,47,932

Source: India’s external debt: A status report, 2013-14, Ministry of Finance, August, 2014PR: Partially revised, QE: Quick estimates

2.2.2 Predominance of the automatic route

Table 2.5, which presents the pattern of sanction of ECB reveals that a dominant part ofthe borrowing is under the automatic route. The recent rise in the share of borrowingunder the approval route reflects large size loans by non-financial companies in thepower, airline, and mineral sectors.

Table 2.5: Amounts sanctioned under the automatic and approval route

Year Automatic Route Approval route Total in USD MillionNumber of approvals Amount in USD Million Number of approvals Amount in USD Million

2007-08 556 20262 62 11276 315382008-09 407 9455 150 8955 184102009-10 516 13915 84 7754 216692010-11 649 16287 77 9488 257762011-12 1001 25822 73 10144 359672012-13 825 18395 92 13651 320462013-14 573 12346 140 20892 33238

2.2.3 Increasing borrowing of longer maturity

Table 2.6 presents the maturity-wise distribution of ECB. The requirement of minimummaturity keeps the maturity period high. Yet, there has been an increase in the proportionof long term loans (beyond 10 year maturity) till 2012-13. In tandem, there is a decline inthe proportion of loans with a maturity of less than 5 years. However, 2013-14 witnessedan increase in the short-term loans and a decline in loans with longer maturity.

2.2 Description of outcomes 17

Table 2.6: Maturity-wise distribution of ECB (Amount in USD million)

Maturity period 2009-10 2010-11 2011-12 2012-13 2013-14(In years)≤ 5 6,850 6,161 7,874 8,366 18,208

(33.5) (24.6) (22.3) (26.1) (54.8)>5 and ≤ 7 11,547 15,390 22,653 17,117 11,942

(56.4) (61.6) (64.1) (54.3) (35.9)>7 and ≤ 10 1,720 2,844 3,167 2,798 2,241

(8.4) (11.4) (8.9) (8.7) (6.7)>10 330 603 1,660 3,749 841

(1.6) (3.2) (4.7) (10.9) (2.5)Total 20,447 24,998 35,354 32,031 33,232

Source: RBI

2.2.4 Dominance of non-resident foreign banksTable 2.7 presents the lender profile of ECB. The non-resident foreign banks have beenthe major lenders throughout. The non-resident Indian banks extended about one fifth oftotal lending.

Table 2.7: Profile of lenders (Amount in USD million)

Creditor Category 2009-10 2010-11 2011-12 2012-13 2013-14Non-Resident Foreign Bank 8,824 13,553 17,023 15,044 20,752Non-Resident Indian Bank 2,237 5,164 9,034 6,079 6,645Non-Resident Company 3,472 2,512 4,282 4,585 2,772International Investors 3,336 1,185 2,494 3,183 1,533International Financial Institutions 2,578 2,584 2,521 3,140 1,530Total 20,447 24,998 35,354 32,031 33,232

Source: RBI

2.2.5 All-in-cost ceilingsTable 2.8 presents the cost distribution of ECB over the years. The bulk of the borrowingtakes place in the bracket ‘Greater than Libor plus 100 bps upto Libor plus 300 bps’.A sizeable proportion of funds was borrowed at higher spreads (greater than 300 basispoints) over 6 month LIBOR in 2011-12. However, there has been a decline in borrowingat higher spreads (greater than 300 basis points) in the last two years.

Table 2.8: All-in-cost analysis (Amount in USD million)

Margin Range 2009-10 2010-11 2011-12 2012-13 2013-14≤ Libor +50 bps 238 228 673 322 1,425> Libor +50 bps and ≤ Libor +100bps

1,599 433 1,580 1,275 5,092

> Libor+ 100 bps and ≤ Libor+300 bps

7,280 13,680 12,916 14,386 15,140

≤ Libor +300 bps (68.8) (64.3) (53.0) (64.2) (79.5)> Libor+300 bps and ≤ Li-bor+500 bps

4,120 7,960 13,416 8,994 5,571

≥ Libor +300 bps (31.2) (35.7) (47) (35.8) (20.5)Fixed Rate 7,210 2,697 6,769 7,054 6,004Figures in parentheses indicate % to total floating rate loans

Source: RBI

18 Background

2.2.6 Expanding end-usesTable 2.9 presents the end-use pattern for ECBs. While the emphasis of the ECBframework has traditionally been on the use of funds for the import of capital goods,new projects, and modernisation or expansion of existing production units in the realsector, the table shows that the proportion of ECB for these purposes has witnessed adecline in recent years. In tandem, the proportion of borrowing for other permissibleactivities, such as refinancing of old loans, onward lending, working capital requirementand refinancing of rupee loans has increased.

Table 2.9: End-use pattern (Amount in USD million)

End-use 2009-10 2010-11 2011-12 2012-13 2013-14Import of capital goods 5,665 4,782 5,826 8,879 6,586

(27.7) (19.1) (16.5) (27.7) (19.8)Overseas acquisition 860 1,111 1,171 1,263 6,584

(4.2) (4.4) (3.3) (3.9) (19.8)Refinancing of old loans 1,033 150 1,729 785 3,336

(5.1) (0.6) (4.9) (2.5) (10)New project 2,792 2,246 3,151 3,113 1,965

(13.7) (9) (8.9) (9.7) (5.9)Power 878 2,452 5,946 3,137 1,535

(4.3) (9.8) (16.8) (9.8) (4.6)Rupee expenditure 3,555 4,950 7,015 3,806 2,654

(17.4) (19.8) (19.8) (11.9) (8)Working capital 5 3 0 34 2,600

(0) (0) (0) (0.1) (7.8)Modernisation 2,569 2,601 3,646 2,845 1,451

(12.6) (10.4) (10.3) (8.9) (4.4)Redemption of FCCBs – – 1,350 1,413 64

(0) (0) (3.8) (4.4) (0.2)Onward/Sub-lending 793 1,552 1,233 2,933 1,608

(3.9) (6.2) (3.5) (9.2) (4.8)Refinancing of rupee loans – – – 1,113 1,408

(3.5) (4.2)Railways 0 0 0 0 900

(0) (0) (0) (0) (2.7)Replacing the bridge finance 0 0 0 0 800

(0) (0) (0) (0) (2.4)Port 0 220 1,214 191 407

(0) (0.9) (3.4) (0.6) (1.2)Mining, exploration and refining 0 0 0 0 267

(0) (0) (0) (0) (0.8)Telecommunication 1,215 1,100 20 460 235

(5.9) (4.4) (0.1) (1.4) (0.7)Road 0 402 555 215 38

(0) (1.6) (1.6) (0.7) (0.1)Others 1,082 3,428 2,498 1,853 794

(5.3) (13.7) (7.1) (5.8) (2.4)Grand total 20,447 24,998 35,354 32,031 33,232Figures in parentheses indicate % to total

Source: RBI

2.2.7 Broad patternGenerally, the outcomes are market determined. The broad pattern emanating from theabove analysis is as follows:

• ECB has emerged as a major source of finance for Indian firms and, therefore, ofeconomic growth.

• The service sector, the growth driver of the economy, has minimum access to ECB.• A significant proportion of ECB is being accessed for refinancing of old loans and

onward lending.

2.3 Deficiencies in the extant arrangement 19

• There is an increase in number of borrowing under the automatic route reflectingdecreasing intervention of State in individual transactions.

• Non-resident Indian banks extend a sizeable portion of ECB.• The bulk of borrowing is in the maturity bracket of 5-7 years reflecting currency

exposure over a longer time horizon.• There is a preference to borrow at floating rates indicating acceptance of market

determined outcomes.• The bulk of the borrowing happens at the lower end of the permissible cost

reflecting ability of the Indian firms to strike good deals.

2.3 Deficiencies in the extant arrangementThe stakeholders have brought up the following deficiencies in the extant regime govern-ing ECB to the notice of the Committee.

2.3.1 ComplexityThe 2014 Master Circular issued by RBI on ECB devotes twenty-four pages to specifyas to who can borrow, for what purposes it can borrow, from what sources it can borrow,what amount it can borrow, on what terms it can borrow and subject to what obligations.There are different eligibility norms for each firm wishing to borrow in foreign currencyand it can borrow on specified terms, from specified lenders, for specified purposesand with specified obligations. For example, a NBFC-Infrastructure Finance Companycan borrow up to 75% of its own funds for on-lending to infrastructure sector if ithedges 75% of its currency exposure. An NBFC-AFC can borrow up to 75% of its ownfunds subject to a maximum of USD 200 million per financial year with a minimummaturity of five years for financing of import of infrastructure equipment for leasing toinfrastructure projects provided it hedges the currency exposure in full. The purposesof borrowing are essentially the same in both the cases while the amount that can beborrowed, the terms (maturity) of borrowing and the hedging obligation are different.Take another example. A MFI registered as a society, trust or co-operative can borrowup to USD 10 million from international banks, multilateral financial institutions, exportcredit agencies, overseas organisations and individuals provided it has a satisfactoryborrowing relationship with a bank and its management committee is ‘fit and proper’.A NBFC-MFI can borrow from international banks, multilateral financial institutions,foreign equity holders and overseas organisations. While the end-use is essentially thesame in both the cases, the lenders, eligibility for borrowing, the amount that can beborrowed, and the status of fit and proper are different.

Table 2.10 presents an example of complexity where specified borrowers can borrowfrom specified lenders only. A section 25 company can borrow from international banksand not from government owned development financial institutions, while an exportcredit agency can lend to MFIs registered as trusts and not to NBFC-MFIs.

The Foreign Exchange Management Act, 1999 and the regulations made and circularsissued thereunder govern the ECB. RBI issues general directions through A.P. (DIRSeries) Circulars under section 10(4), section 11(1) and section 11(2) and amends theregulations like FEMA 3, FEMA 8 and FEMA 120 framed under the Foreign ExchangeManagement Act, 1999 to change the ECB framework. It consolidates these circulars

20 Background

Table 2.10: Eligible Borrower and Recognised Lender Combinations

Recognised Lender Eligible BorrowerNGOs inMicro-Finance

Section 25companiesin microfi-nance

MFIs reg-istered astrusts

NBFC-MFIs

NBFCsleasingequipment

Other bor-rowers

International banks Yes Yes Yes Yes Yes YesInternational capital markets No No No No No YesMultilateral financial institutions Yes Yes Yes Yes Yes YesRegional financial institutions No No No Yes Yes YesGovernment owned development finan-cial institutions

No No No No No Yes

Export credit agencies Yes Yes Yes No Yes YesSuppliers of equipment No No No No No YesForeign collaborators No No No No No YesForeign equity holders No Yes No Yes No YesOverseas organisation Yes Yes Yes Yes No NoIndividuals Yes Yes Yes No No NoIndirect equity holders No No No No No YesGroup company No No No No No Yes

and amendments on July 1 of every year into a master circular and updates the sameto incorporate changes throughout the year. While the master circular is for generalguidance, the users have to use the circulars and regulations to be on the right side ofthe law. Since 2000 to July 1, 2014, there have been 18 amendments to regulations and120 A.P. (DIR Series) Circulars. A user has to go through these amendments and thecirculars in addition to the Act and the regulations.

2.3.2 Prescriptive

The extant framework is too prescriptive with excessive micro-management of eachaspect of borrowing by the regulator. It prescribes different caps on borrowing fordifferent categories of eligible borrowers for different end-uses. For example, underthe automatic route, for corporates, the limit is USD 750 million; corporates in hotel,hospital, and software sectors are allowed to borrow USD 200 million; and NGOsengaged in micro-finance are allowed to borrow USD 10 million per year. The useof ECB proceeds for development of integrated township was allowed till May 2007,withdrawn in May 2007 and re-allowed in January 2009. While one can borrow towardspayment for 2G spectrum allocation under the automatic route, the borrowing for 3Gspectrum allocation is considered under the approval route. Some borrowings needto have some hedging, some others need partial hedging and some do not need anyhedging. It is difficult to decipher the principles guiding the decision for allowing certaincategories of borrowers to borrow up to a certain amount of ECB while restricting others,allowing, withdrawing and re-allowing the facility for a sector, requiring hedging incertain cases and not in other cases, allowing borrowing for 2G spectrum under theautomatic route and for 3G spectrum under the approval route, etc.

It is appreciated that such a large number of prescriptions is the result of usingECB framework to promote various objectives simultaneously. For example, ECB wasused to manage currency fluctuations - it was discouraged to stem sharp appreciationof the rupee during 2006-08, while it was encouraged in 2013 to stem depreciation of


the rupee.57 Similarly, banks are not allowed to give guarantee and there are severalprohibitions, restrictions and restrictive permissions on banks and NBFCs for availingECB to maintain integrity of financial system.58 The use of ECB for development ofintegrated township was withdrawn in May 2007, keeping in view sharp rise in assetprices, especially property prices. As a sector specific measure, it was re-allowed inJanuary 2009.59 While some press releases indicate the objective of the prescription,often the objective is either not stated or vague. Ideally every provision prescribing arequirement should explicitly state the rationale for the same.60 The stakeholders mustknow whether a particular prescription addresses a market failure, promotes exchangerate stability, maintains integrity of the banking system or any other. Further, as theGovernment charts out its reforms strategy, its chances of success increases if it keepsthe assignment rule firmly in mind. It is efficient to assign a specific objective to eachinstrument of policy. The consequences of pursuing multiple objectives through oneinstrument can be adverse.61 The ECB policy should not be used, to the extent possible,to pursue so many objectives such as development of a particular sector.

Mr. Padmanabhan does not agree with the above observations and is of the viewthat the measures discussed above were implemented keeping in view larger macroobjectives. Further, the borrowing regime for financial sector entities like banks andNBFCs had always been accorded a different treatment for stability considerations.

Absence of clear principles for determining eligible borrowers leads to an additionof additional categories to the list of eligible borrowers, as and when a representationis received. There were only two broad categories of eligible borrowers in 2004.62

Over one decade, the list has turned into a complex document with sixteen categoriesof eligible borrowers ranging from NBFCs to HFCs, Special Purpose Vehicles (SPVs),co-operative societies, SIDBI, and service sector units. In addition, certain sectorsfacing financial difficulties are allowed ECB for working capital requirement for a fixedwindow.63 This creates problems of political economy. Sectors which are not allowed toavail ECB under the automatic route today keep on persuading the authorities to addthem to the list. Additionally, they apply under the approval category and persuadethe authorities to accede to their requests. This is antithetical to the rule of law andadds hugely to administrative workload and enforcement of law without addressing anymarket failure.

57See, Padmanabhan, see n. 2.58See Part I(I)(A)(viii), Reserve Bank of India, 2014 Master Circular, see n. 16.59See, Ministry of Finance, Review of External commercial borrowings (ECB) policy, Jan. 2, 2009, URL:

http://finmin.nic.in/press_room/2009/jan_details.asp?pageid=7#ECBPolicy02012009(visited on 12/10/2014).

60See, Supreme Court of India, Daiichi Sankyo Company Ltd. v. Jayaram Chigurupati and Ors. (2010)7 SCC 449.

61See, Subir Gokarn, You can’t kill two birds... Nov. 2, 2014, URL: http://www.business-standard . com / article / opinion / subir - gokarn - you - can - t - kill - two - birds -114110200711_1.html (visited on 12/09/2014).

62These were: (a) Financial institutions dealing exclusively with infrastructure and export finance; and(b) Banks and financial institutions which had participated in textile restructuring package subject toprudential norms imposed by RBI.

63See, Reserve Bank of India, 2014 Master Circular, see n. 16.

22 Background

2.3.3 Non-neutrality

The extant framework allows some sectors and not others, allows some companiesand not others, and generally restricts banks, financial institutions and service sectorto access ECB.64 It does not permit ECB for general corporate purposes, includingworking capital. However, it permits ECB for working capital in civil aviation sectorunder the approval route.65 Further, it allows infrastructure firms to utilise 25% of ECBproceeds towards refinancing of rupee loans. It, however, allows firms in the powersector to use 40% of ECB proceeds towards refinancing of rupee loans.66 The frameworkimposes different obligations, such as hedging, on different kinds of borrowers. Thisapproach obviously promotes certain sectors or end uses at the cost of others and therebycontributes to market failure in terms of resource allocation. In fact, a change in policyoccasionally carries a statement that it is a sector specific measure.67 Thus, all sectors ofthe economy do not have the same level playing field. Promotion of a particular sectorwas probably the objective at the relevant time, but is no more relevant today and doesnot gel with the contemporary economic thinking.

It is instructive to look at reforms in the capital market. The Capital Issues (Control)Act, 1947 empowered the authorities to determine the eligible firms to access thedomestic capital market and the terms of access. However, in sync with economicthought of the early 1990s, the Capital Issues (Control) Act, 1947 was repealed. Nowthere is no restriction on a firm to raise any amount for any purpose and it does soon terms acceptable to the market. No sector gets preferential treatment for raisingresources from market.

Occasionally, ECB interventions have yielded unintended consequences. For exam-ple, it was specified on August 7, 2007 that ECB, under both automatic and approvalroutes, beyond USD 20 million would be used only for foreign currency expenditure forpermissible uses and could not be remitted to India.68 Reflecting the restrictions on theuse of ECB for rupee expenditure, the proportion of borrowing used for import of capitalgoods increased from around 25% during 2005-06 and 2006-07 to 41% during 2007-08,and the share of rupee expenditure fell from around 14% to 3% over the same period.69

Figure 2.1 shows the seasonally adjusted levels of capital goods imports and domesticcapital goods production index (IIP), both indexed to January 2004 as 100. It shows thatthe restrictions imposed on August 7, 2007 resulted in an increase in import of capitalgoods. Domestic firms may have substituted away from domestic capital goods in orderto obtain cheap credit. When this end-use restriction was rescinded on October 23, 2008,import of capital goods dropped sharply.70

64See, Working Group on Foreign Investment, see n. 2.65See, Reserve Bank of India, External Commercial Borrowings (ECB) for Civil Aviation Sector,

RBI/2011-12/523 A. P. (DIR Series) Circular No. 113, Apr. 24, 2012.66See Part I(I)(B)(v)(f), Reserve Bank of India, 2014 Master Circular, see n. 16.67See, Ministry of Finance, Review of External commercial borrowings (ECB) policy, July 1, 2009,

URL: http://pib.nic.in/newsite/PrintRelease.aspx (visited on 12/10/2014).68See, Reserve Bank of India, Review of External Commercial Borrowings (ECB) Policy, RBI/2007-

2008/112 A. P. (DIR Series) Circular No. 04, Aug. 7, 2007.69See, Ila Patnaik and Ajay Shah, “Did the Indian Capital Controls Work as a Tool of Macroeconomic

Policy?”, in: IMF Economic Review 60.3 (Sept. 2012), pp. 439–464.70See, R. Mohan and M. Kapur, Managing the impossible trinity: Volatile capital flows and Indian

monetary policy, Working Paper 401, Stanford Center for International Development, 2009.


2007 2008 2009 2010

500

700

900

2007 2008 2009 2010

2007−08−07 2008−10−23

Capital goods importsIIP (Capital goods)

Figure 2.1: Controls that encouraged imports of capital goods

Mr. Padmanabhan believes that the above analysis is not related to subject ofdiscussion. The measure only attempted to ensure that ECBs raised for import purposesshould not be remitted to India. This was to manage concerns arising out of capitalflows. To say that this led to increase in imports may be right in fact, but illogical to theissue that is being flagged.

2.3.4 DiscretionaryBroadly there are three categories, namely, prohibited categories of ECB, ECB underthe automatic route and ECB under the approval route. It is not obvious why a particularcategory (e.g. 2G spectrum) is included under the automatic route and another (e.g. 3Gspectrum) under the approval route. Even if there is a valid reason to do so, popularperception is that this is a discretionary decision of the authorities. This brings in theproblems of political economy, making it all the more necessary that any interventioncarries an explicit rationale for appreciation of its basis. Further, a prospective borroweris aware up front of the specified parameters under the automatic route. However, heis not very clear on what would be permitted or which parameter would be relaxedunder the approval route. Since the contours of the approval route is not very clearto everybody, only the adventurous borrowers take benefit of this while the others aredenied. Similarly, prepayment beyond USD 500 million is considered on a case to casebasis. One does not know what considerations would persuade the authorities to allowprepayment in a particular case. There is no order in the public domain indicating why aparticular request for borrowing was approved and why another was rejected. Further,these decisions are not appealable. If such orders were freely and publicly available, arich jurisprudence would develop around the process of approvals. This in turn wouldbring legal clarity and predictability in the system. The regulatory discretion rendersthe extant framework unpredictable. The Committee, however, notes that to amelioratethe deficiencies in the approval process, RBI is taking measures to implement the non-legislative recommendations of the Financial Sector Legislative Reforms Commission(FSLRC).71

71See, Reserve Bank of India, RBI announces Timelines for Regulatory Approvals and Citizens’ Charterfor Delivery of Services, Press Release: 2013-2014/2481.

24 Background

The need for approval for any transaction is increasingly becoming outdated. Thecountry shifted from a command and control regime to a liberalised regime where theeconomic agents have freedom to take decisions on their own, subject to compliance withnorms prescribed in the regulations and where the regulations are made, after followingthe due process, only to address the identified market failures. For example, no companyrequires any approval for making a public issue in the country. The requirement ofapproval for raising resources takes the country back by two decades to a merit basedregulatory regime with attendant consequences.

2.3.5 Currency mismatchSection 3.1 describes contemporary economic thinking about the market failure. Theonly potential market failure associated with ECB is systemic risk arising from currencyexposure. Hedging is a convenient mode of addressing this problem. However, theextant framework requires only a few categories of Indian firms to hedge their foreigncurrency exposure. These are: ECB by NGOs engaged in micro-finance activities andMFIs; ECB by NBFCs categorised as IFCs; ECB where IFCs have availed of creditenhancement facility and the same gets invoked and the novated loan is designated inforeign currency; ECB by HFCs; NBFC-AFCs; ECB by SIDBI where it has been on-lentto Micro Small and Medium Enterprise (MSME) sector in Indian rupees. Other firmstaking ECB are not being mandated to hedge their currency risk.72

The extent to which firms are taking on currency risk on a substantial scale byundertaking ECB can potentially be answered using firm-level data on ECB. However,this data could not be accessed by this Committee despite its best efforts. Hence, theresearch team developed a heuristic measure of a firm’s natural hedge level.73 For allfirms that report foreign currency borrowing, the annuity payable for those firms at theend of a financial year based on their quantum of borrowing and an average rate ofinterest was calculated.74 This imputed liability arising out of ECB was matched withthe firms’ receivables arising out of their net exports. This gave a measure of the levelof a firm’s natural hedge. Further, all foreign borrowing firms were divided into threecategories of hedge coverage:

• High : Net exports for the year is more than 80% of the annual repayment of ECBfor the year.

• Low: Net exports for the year is less than 80% but more than 20% of the annualrepayment of ECB for the year.

• None: Net exports for the year is less than 20% of the annual repayment of ECBfor the year.

Table 2.11 shows that more than 50% of the firms that undertake ECB have small orno foreign currency receivables to naturally hedge the foreign currency liability arisingfrom ECB. At the same time, around 40% of the firms that avail ECB have a high level

72See Part I(I)(A)(i)(k), Part I(I)(A)(iii)(c)/(d)/(e), Part I(I)(B)(i)(n), Part I(I)(B)(vii), Reserve Bank ofIndia, 2014 Master Circular, see n. 16.

73For this purpose, the research team used data from the Prowess database of Centre for MonitoringIndian Economy Pvt. Ltd. (CMIE).

74The average rate of interest is taken as 300 basis points over 6 months LIBOR. The average maturityperiod is 5 years.


Table 2.11: Natural hedge coverage of foreign borrowing firms

Year No. of ECB Firms High Low NoneAs % of total ECB firms

2004 530 36.23 3.40 60.382005 981 41.28 2.75 55.962006 1011 40.75 3.46 55.792007 977 41.15 3.89 54.962008 1019 40.04 4.12 55.842009 922 38.39 3.69 57.922010 935 36.58 3.53 59.892011 779 38.00 3.47 58.542012 772 37.95 3.50 58.552013 625 40.00 2.88 57.12Source: CMIE Prowess

of natural hedge coverage through their net exports proceeds. However, as Table 2.12shows, the value of naturally unhedged borrowing far exceeds the value of naturallyhedged borrowing. The quantum of naturally unhedged ECB is 3-4 times the amountof borrowing that are naturally hedged. This suggests that around 50% of the firmsundertaking ECB, which constitute over 70% of the ECB amount borrowed in a year,are in need of financial hedging to cover their risks arising out of foreign currencyborrowing.

Table 2.12: Natural hedge coverage of foreign borrowing firms

Year High Low NoneAs % in value terms

2004 19.08 0.85 80.072005 24.60 3.84 71.562006 18.12 7.78 74.102007 21.09 5.43 73.482008 18.21 8.43 73.362009 19.48 4.78 75.742010 15.66 5.71 78.632011 14.77 2.65 82.582012 15.89 1.91 82.202013 13.78 6.82 79.40Source: CMIE Prowess

The firms which have no natural hedges and no financial hedges would face financialdistress if there was a sudden depreciation of the exchange rate. A recent report raisesconcerns about the rising asset-liability mismatch of the active international debt issuersin China and India.75 This has grave financial stability concerns. The extant framework,which does not impose any hedging obligation on most Indian firms accessing ECB, isnot equipped to address this concern.76 This concern has been very succinctly capturedin a speech as under:77

75See, Michael Chui, Fender Ingo, and Sushko Vladyslav, Risks related to EME corporate balancesheets: the role of leverage and currency mismatch, BIS Quarterly Review, BIS, 2014.

76Some categories of borrowers like NBFCs, NGOs, SIDBI, CICs, HFCs etc. are required to hedge theforeign currency exposure under the present regulations. See Part I(I)(A)(i)(k), Part I(I)(A)(iii)(c)/(d)/(e),Part I(I)(B)(i)(n), Part I(I)(B)(vii), Reserve Bank of India, 2014 Master Circular, see n. 16.

77See, Harun R Khan, Indian foreign exchange market: Recent developments and the road ahead,Oct. 6, 2014, URL: http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=919 (visitedon 11/18/2014).

26 Background

... in India, there is emerging anecdotal evidence of reduced propensity to hedge foreignexchange exposures arising out of a sense of complacency. The unhedged exposures inrespect of External Commercial Borrowings (ECBs)/ Foreign Currency Convertible Bonds(FCCBs) lead to large scale currency mismatches in view of the bulk amount borrowedby domestic corporates for longer tenors with limited or no natural hedges. Further, theincreasing use of bond route for overseas borrowings exposes the domestic borrowersto greater roll-over risk. As per indicative data available with the Bank, the hedge ratiofor ECBs/FCCBs declined sharply from about 34 per cent in FY 2013-14 to 24 per centduring April-August, 2014 with very low ratio of about 15 per cent in July-August 2014.Large scale currency mismatches could pose serious threat to the financial stability incase exchange rate encounters sudden depreciation pressure. It is absolutely essential thatcorporates should continue to be guided by sound hedging policies and the financing banksfactor the risk of unhedged exposures in their credit assessment framework.

The Committee observes that the tightening or easing of ECB regulations is notmotivated by systemic risk concerns associated with ECB. Instead, easing of ECB regu-lations is preceded by exchange rate depreciation while tightening of ECB regulations ispreceded by exchange rate appreciation.78 ECB is discouraged to stem rupee appreci-ation and encouraged to stem rupee depreciation.79 Some, however, believe that suchregulatory responses, although influenced by exchange rate movements, have limitedeffectiveness in addressing exchange rate objectives.80

2.3.6 Deficiencies summed up

Any complex central planning system of government intervention is vulnerable toproblems of political economy and lobbying by interested parties. The extant frameworkfor ECB is no exception. Further, the extant framework is complex, prescriptive,discretionary and not neutral and has outlived its utility. The regulations lack clearlegal and economic principles relevant today. Lack of predictability of regulations andceilings on ECB makes it hard for corporations to plan borrowing, and even to serviceold loans that need to be refinanced. This creates added uncertainty and risk, and drivesup the cost of financing.

State intervention in the financial markets should always be motivated by the possi-bility of a market failure. The only potential market failure in the field of ECB involvedsystemic risk concerns. Section 2.3.5 illustrates how the extant framework falls shortof addressing such risk. Table 2.11 and Table 2.12 show that around 50% of the ECBborrowing firms, which constitute over 70% of the ECB amount borrowed in a year,are in need of financial hedging to cover their risks arising out of foreign currencyborrowing.

Given the deficiencies elaborated above, it is not surprising that there is a clamourfor a comprehensive review of the ECB framework.81 While there may be justificationfor this segmented approach to ECB regulations in the past, the Committee is of the viewthat these regulations need comprehensive review and simplification in today’s context

78See, Radhika Pandey et al., Motivations for Capital Controls and Their Effectiveness, Working Papers15-5, Bank of Canada, 2015.

79See, Padmanabhan, see n. 2.80See, Pandey et al., see n. 78.81See, Committee on Fuller Capital Account Convertibility, see n. 2; Committee on Financial Sector

Reforms, see n. 2; Working Group on Foreign Investment, see n. 2; and, Padmanabhan, see n. 2.

2.4 International experience 27

when Indian corporates and the economy are becoming increasingly internationalisedthereby having to compete with international players.

2.4 International experience

2.4.1 A comparative analysis

From an Indian perspective, comparative policy analyses are more productive andinteresting when done with BSST countries. These countries are similar to India interms of size and governance arrangement.82

Restrictions on amount of borrowing

Table 2.13 presents a comparison of the regulatory frameworks governing the maximumamount of foreign currency borrowing in BSST countries. In most of the countriesthere is no restriction on the amount that can be borrowed by a firm. The borrowers arerequired to report their transactions to the ADs within a stipulated time-frame.

Table 2.13: Is there a cap on foreign borrowing?

Country South Korea Brazil South Africa TurkeyApprovals Limited None None None

Conditions ECB more thanUSD 30 Millionrequires approvalfrom Ministryof Strategy andFinance.

Reporting within 30days by AD’s.

All approvals byAD’s who oper-ate the exchangecontrols manual.

Source: Foreign Exchange Transactions Act; International Capital and Foreign Exchange Market Regu-lation; South African Exchange Control Manual; Decree No.32 on the Protection of the Value of TurkishCurrency

Restrictions on who can borrow

Table 2.14 presents a comparison of the regulatory restrictions governing eligibility ofborrowers. None of the BSST countries impose restrictions on the firms that can borrowabroad.

Table 2.14: Is there a restriction on who can borrow?Country South Korea Brazil South Africa TurkeyBorrowers None None None None

Conditions Distressed borrow-ers need approval


82For a detailed analysis of why BSST countries offer a better benchmark of comparison see, WorkingGroup on Foreign Investment, see n. 2.

28 Background

Restrictions on who can lendTable 2.15 presents that broadly there are no restrictions on the lenders. In Brazil andSouth Africa the restrictions are linked to the credit rating of the lender. The lendermust be of ‘investment grade’ to be eligible to lend. Additionally in South Africa, theregulations require that the foreign lender should not have any domestic interests.

Table 2.15: Is there a restriction on who can lend?Country South Korea Brazil South Africa TurkeyLenders None Yes Yes None

Conditions Only an Investmentgrade lender canlend

Investment gradelender with noSouth Africaninterests can lend


Restrictions on maturity of borrowingTable 2.16 shows that the international norm is towards reducing the minimum maturityof firms’ foreign currency denominated borrowing to one year.

Table 2.16: Is there a restriction on maturity of borrowing?

Country South Korea Brazil South Africa TurkeyMaturity Minimum maturity

of one yearMinimum maturityof one year; openmaturity not permit-ted

Minimum maturityof one month

Minimummaturity ofone year


Restrictions on cost of borrowingTable 2.17 shows that broadly countries do not impose all-in-cost ceilings on borrowing.The only exception is South Africa, where the ceiling rate is base rate plus 2% forforeign currency denominated loans. In Brazil, the regulations are guided by principlesthat link cost of borrowing to the market conditions of firms.

Table 2.17: Is there a restriction on the cost of borrowing?

Country South Korea Brazil South Africa TurkeyAll-in-cost None None Yes None

Conditions Costs and otherconditions of op-erations shouldmaintain compat-ibility with thoseusually observedin internationalmarkets; undefinedcharges are notallowed.

Base rate + 2% forFCY loans; Baserate + 3% for Randloans


2.4 International experience 29

Restrictions on the end-useTable 2.18 shows that the BSST countries do not impose any end-use restrictions onforeign borrowing. In South Africa, the only restriction is that the borrowed fundscannot be used for investments in sinking funds.

Table 2.18: Is there a restriction on end-use of the borrowed amount?Country South Korea Brazil South Africa TurkeyEnd-use restrictions None None Yes None

Conditions Special emer-gency circum-stances

Investment insinking funds

Source: Foreign Exchange Transactions Act; International Capital and Foreign Exchange Market Regulation;South African Exchange Control Manual; Decree No.32 on the Protection of the Value of Turkish Currency

2.4.2 Hedging facilityMany of the comparable jurisdictions have adequate facilities to enable economicagents to hedge their currency exposure, including their exposure from foreign currencyborrowing. Brazil has well-developed exchange-traded and Over The Counter (OTC)derivatives markets and thereby provides conducive opportunities for hedging foreigncurrency borrowing. A prominent reason why the 1999 crisis in Brazil did not disruptgrowth was that the private sector and non-financial corporate sector had hedged theirdollar liabilities.83 Also, unlike many other countries with OTC derivatives markets,Brazil has reporting requirements for OTC transactions. This coupled with sophisticatedrisk management practices in Brazil provided impetus to the development of exchangetraded currency derivatives. The market is deep and liquid with no restriction on foreigninvestor participation. It offers a wide array of instruments like futures, options, flexoptions and cross-currency swaps.84

Brazil has a system of electronically registering every derivative transaction in acentralised information repository. The Brazilian central bank requires companies toregister their derivative transactions linked to the raising of funds abroad. Financialinstitutions must register derivatives such as options, forward contracts, futures contracts,and swaps, that are linked to the cost of indebtedness originally contracted in loantransactions entered into between persons resident or domiciled in Brazil and personsresident or domiciled abroad, including individuals and non-financial legal entities.85

In addition to the effective regulatory structures to facilitate hedging of currencyexposures, Brazil has retained the flexibility to impose macro-prudential controls toaddress the financial fragility concerns arising from unfettered capital inflows. In 2011,Brazil imposed a 6% tax on new foreign loans with maturities up to a year, whichwas later extended to loans with maturities up to 2 years.86 In contrast to the granularframework of controls in India, this was uniformly applicable to all forms of foreignloans with a maturity up to 2 years.87

83See, Randall Dodd and Stephany Griffith-Jones, Brazil’s Derivatives Markets: Hedging, CentralBank Intervention and Regulation, Ford Foundation, 2007.

84See, ibid.85See, Banco Central Do Brasil, Circular 3474, Nov. 11, 2009.86See, WTO, OECD, and UNCTAD, Report on G20 Investment Measures Taken between 2 April 2009

and 15 October 2014, Report, 2014.87Another instrument to check unrestricted debt flows could be the auctioning of the right to borrow

30 Background

Box 2.1: Hedging assessment strategy in South Africa

The assessment of hedging in South Africa is based on the following information:

• Are the facilities required to cover a firm’s exposure to possible lossesarising from adverse movements in foreign exchange rates?

• Is documentary evidence produced confirming the nature and extent of theunderlying exposure at time of pay away?

• Is the transaction clearly identifiable as a hedge?• Does it reduce the exposure to risk?• Will it be designated as a hedge at the time it is entered into?• Does the customer apply its criteria of designating transactions as hedges

on a consistent basis?• Is there a high correlation between the price of the hedge contract and the

underlying asset, liability or commitment (“the underlying transaction”)?

The South African exchange control framework lists the requirements with respectto hedging by entities.88 Box 2.1 outlines the regulatory requirements through which anassessment of hedging is made.

2.4.3 Lessons from peer group countriesTo summarise, the key lessons emerging from the study of the BSST countries are:

• These countries have rationalised their ECB frameworks. There are generallyno restrictions on borrowers, lenders, all-in-costs, end-use, etc. The nature ofintervention focusses only on addressing the macroeconomic risks.

• Robust regulatory structures have been put in place to ensure that firms are ableto hedge the risk arising from exchange rate fluctuations. Hedging is possiblebecause the regulatory structure facilitates borrowers’ access to sophisticatedmarket for currency derivatives.

• Macro-prudential policies have been used to address the financial stability impli-cations of unrestrained capital inflows.

On the basis of the above analysis, the Committee notes that the Indian regulatoryframework governing ECB is not in sync with global best practices and contemporarythinking. Therefore, the Committee concludes that the economic rationale underlyingthe framework needs to be reviewed thoroughly and the regulations must be accordinglymodified.

abroad. In 2009, there was a proposal in India to auction corporate entitlements to borrow abroad inan attempt to address the concerns of surge in capital flows. The proposal could not be implementedbecause of differences in opinion between RBI and the government. The ECB auction idea was originallyfloated by Arvind Virmani, formerly chief economic advisor to the finance ministry. In a working paper inNovember 2007, he had suggested this as a flexible and transparent way of managing capital flows. See,Arvind Virmani, Macro-economic Management of the Indian Economy: Capital Flows, Interest Ratesand Inflation, Working Paper, Ministry of Finance, Government of India, 2007.

88See, Section F.7 South African Reserve Bank, South African Exchange Control Manual, Section 0F.7, Dec. 10, 1961.

3 — Guiding principles

The Committee’s review of the extant regulatory framework surrounding ECB hasbeen informed by the reform strategy articulated in recent expert committee reports,including the S.S. Tarapore Committee Report (2006), Percy Mistry Committee Report(2007), Raghuram Rajan Committee Report (2008), U.K. Sinha Committee Report(2010), B.N. Srikrishna Committee Report (2013), Report I (2013) and Report II (2014)of this Committee. Accordingly, this Chapter focuses on understanding market failureinherent in foreign currency borrowing and the principles that should guide the choiceof intervention to address the market failure.

3.1 Market failure3.1.1 Sources and nature of currency exposure

Exposure to foreign currency and the consequential exchange rate fluctuations is notnecessarily detrimental to a firm. The effect of such fluctuations on the firm’s balancesheet comes about through a combination of factors: natural hedges, foreign currencyborrowing and currency derivatives activity. The four key ideas in this regard are:The classic foreign currency borrower Many firms with large assets outside the country, and/or

large net exports, stand to gain from exchange rate depreciation. For such firms, a cer-tain amount of borrowing in foreign currency reduces risk by neutralising this exposure.Hence, there is a legitimate role for foreign currency borrowing, without hedging throughderivatives, for firms with this kind of exposure.

‘Net exports’ is not just about direct imports and exports The computation of net exports atthe firm level is bedevilled by two problems. First, a firm may buy imported goods froma trading company and thus, in effect be importing even though its financial statementsdo not show imports. Further, all internationally tradeable products have ‘import paritypricing’ where domestic producers sell to domestic buyers at the world price. As anexample, the price at which steel is transacted in India is the price of steel at the LondonMetals Exchange (LME). For the buyer and the seller, the exchange rate impacts upon theproceeds.As an example, consider a firm where all raw materials and all finished goods are tradeable.

32 Guiding principles

Using typical values for manufacturing firms, this firm may purchase raw materials worthRs.60 and sell finished goods worth Rs.100. The currency exposure of the firm is likethat of an exporter, regardless of whether it is actually importing or exporting. Thus,in the example, in an economy where all goods are tradeable, on average, the currencyexposure of manufacturing firms is that of exporters, i.e., these firms gain when there is adepreciation. This gives a natural opportunity for unhedged foreign currency borrowing.At the other extreme is a firm such as an infrastructure service provider, with somepayments in foreign currency (e.g. purchases of steel or of telecom equipment) andall revenues in Indian rupees with no gains in revenues when the currency depreciates.Such firms have the currency exposure of an importer; they stand to lose when there is adepreciation.

The desire to hedge When firms expect RBI to manage the exchange rate, this adversely influ-ences their incentives to hedge exchange rate exposures.89 If RBI indicates that extremecurrency fluctuations will be prevented, firms will hedge themselves against small move-ments but leave large movements unhedged.One situation has been well studied in the historical experience.90 When a country has awell defined exchange rate policy and where changes in the exchange rate are preventedby the central bank, it gives rise to moral hazard, and a build up of currency exposure inthe real sector. This sets the stage for two kinds of effects.First, the firms in the real sector develop a vested interest in the perpetuation of exchangerate policy. This creates lobbying in favour of distortions of monetary policy, and capitalcontrols, through which the exchange rate regime can be sustained. Countries whichface these problems are likely to have difficulties with managing inflation, achievingcounter-cyclical monetary policy, and rationality in capital controls. Second, when theexchange rate does experience large fluctuations, this imposes financial stress upon a largeswathe of the firms of the real sector, which exerts a drag upon Gross Domestic Product(GDP) growth. Policy makers should choose strategies through which these difficultiesare avoided.

The ability to hedge When a firm desires hedging, it runs up against the ability of the financialsystem to produce hedging services at the required maturity for a reasonable cost. Atpresent, the onshore financial system suffers from the poor functioning of the Bond-Currency-Derivatives Nexus, through which large corporations are unable to obtainhedging services in the transaction size and maturity required by them.

Thus, unhedged currency exposure may be detrimental to a firm’s well-being incertain circumstances. Regulatory policies may aggravate the problem by moral hazardand incomplete markets. These issues must be recognised and confronted while thinkingabout policy reforms in this sector.

3.1.2 Is there a market failure?

Firms are free to take commercial decisions and make mistakes occasionally, thusadversely affecting the interests of their owners. Ordinarily, such decisions by firms areuncorrelated. In any given year, the bets placed by some firms pay off while others lose.

89Evidence of this ‘moral hazard’ under Indian conditions is found in Ila Patnaik and Ajay Shah,“Does the currency regime shape unhedged currency exposure?”, in: Journal of International Money andFinance 29.5 (Sept. 2010), pp. 760–769.

90See, Rajeswari Sengupta, Does reserve accumulation lead to higher currency-risk taking in thecorporate sector? Firm-level evidence for Latin America, Working Papers, Santa Cruz Institute forInternational Economics 11-08, 2010.

3.1 Market failure 33

This is the normal rhythm of the market economy. The State has no reason to worry orintervene. The unhedged currency exposure of firms is not different from the myriadother commercial decisions made by firms.

If, however, a large number of firms have unhedged foreign currency exposure, therecan be a correlated failure of numerous firms when a large exchange rate movement takesplace. This correlated failure can depress GDP growth and thus impose externalities uponothers. Thus, there are real systemic risk concerns associated with unhedged foreigncurrency exposure. Possibilities of such market failure motivates State intervention inthis field.

The focus for policy thinking in this field is the question of unhedged foreign currencyexposure. When a firm borrows in foreign currency, its balance sheet is exposed toexchange rate fluctuations. Exchange rate depreciation raises the value of its net foreigncurrency denominated liabilities relative to the net present value of its cash flow.91

This phenomenon was at play in the Mexico crisis in 1994 and the East Asian crisis in1997-98 and has the potential of exposing the economy to systemic risk.92 Contemporarypolicy thinking is geared towards addressing the systemic risk concerns emanating fromforeign currency borrowing.

3.1.3 Experience with unhedged foreign currency exposureIn terms of the desire to hedge, India fares better than many Emerging Market Economies(EMEs) in having greater currency flexibility, though the borrowers like to undertakemore ECB in the managed exchange rate system. However, in terms of the ability tohedge, there are problems in the Indian environment. The Bond-Currency-DerivativesNexus works poorly, thus making it difficult to obtain currency hedges of the kindrequired by large companies. Capital controls interfere with the ability of firms to obtainpositions on currency derivatives, as they rely on the notion of exposure through directimports, direct exports and foreign currency borrowing. Hedging the overall economicexposure of a firm is prohibited. The Non-Deliverable Forward (NDF) market for therupee is inaccessible to most Indian persons owing to capital controls.93

Mr. Padmanabhan is, however, of the view that linkage between NDF and onshoremarket is not allowed for stability concerns and not on account of capital controls, asconcluded.

Recent research shows that firms in India which undertake ECB do not seem toexperience important negative consequences.94 Hence, on balance, the problems of moralhazard and incomplete markets do not seem to be substantially distorting the decisionsof firms. Thus, the empirical foundation supporting market failure associated withunhedged foreign currency borrowing does not substantially exist for India. However,

91See, Barry Eichengreen, Ricardo Hausmann, and Ugo Panizza, “Currency Mismatches, Debt Intoler-ance, and the Original Sin: Why They Are Not the Same and Why It Matters”, in: Capital Controls andCapital Flows in Emerging Economies: Policies, Practices and Consequences, NBER Chapters, NationalBureau of Economic Research, Inc, Oct. 2007, pp. 121–170.

92See, Romain Ranciere, Aaron Tornell, and Athanasios Vamvakidis, “Currency mismatch, systemicrisk and growth in emerging Europe”, in: Economic Policy 25 (Oct. 2010), pp. 597–658.

93See, Sangita Misra and Harendra Behera, “Non Deliverable Foreign Exchange Forward Market: AnOverview”, in: Reserve Bank of India Occasional Papers 27.3 (2006).

94See, Ila Patnaik, Ajay Shah, and Nirvikar Singh, “Who borrows abroad and what are the conse-quences?”, Presented at 12th Research Meeting of NIPFP-DEA Research Program, Mar. 2014.


Box 3.1: Indonesia: Regulations on external debt of non-bank corporations

The Bank Indonesia introduced mandatory hedging requirement for non-bankcorporations on October 28, 2014. While imposing this norm, the Bank notedthat external debt by non-bank corporates require good management in orderto provide an optimal contribution to the national economy without triggeringmacroeconomic instability. Accordingly, the regulation now requires all non-bankcorporations which hold external debt in foreign currency to hedge the foreigncurrency against the Rupiah. The minimum hedging ratio is set at 25%. The Bankmandated this hedging ratio after it observed that the amount of external debt hasspiralled over the past several years, even exceeding the public external debt. Itwas this apprehension that led the Bank to introduce this regulation.a

aSee, BI, Bank Indonesia’s Prudential Principles, see n. 95; also see, BI, Bank Indonesia’sElucidation, see n. 96.

the regulatory framework should embed safeguards to address the potential systemicrisk concerns associated with foreign currency borrowing.

3.2 Interventions to regulate foreign borrowing3.2.1 Hedge

The international experience of foreign currency borrowing shows us that currencymismatch and the balance-sheet infirmities arising from currency mismatch may posea risk to both firms and the banking system, increasing systemic risk. This risk can beameliorated by mandating prudent foreign currency borrowing by firms, wherein thecurrency exposure is either partially or fully hedged. A hedging requirement reduces thecurrency exposure of firms while accessing foreign currency debt from global capitalmarkets. It is noteworthy that in October 2014, Indonesia imposed mandatory hedgingrequirements for non-bank corporations holding external debt in foreign currency.95

Bank Indonesia was motivated to issue this regulation to avert potential adverse effects tothe Indonesian economy, as had occurred during the 1997-1998 crisis, due to spirallingprivate external foreign currency debt.96 Further details about this Indonesian regulationare provided in Box 3.1.

However, it must be noted that mandatory hedging requirement reduces the costadvantage firms may gain from foreign currency borrowing. To illustrate this point,consider a hypothetical example of a AAA rated (lowest level of credit risk) firm inIndia, XYZ corporation, which wants to access a USD 10 million loan for 5 years.XYZ corporation can access credit from Indian capital markets at 10.25% per annum.97

However, if it accesses global capital markets, it can avail the loan of the same tenor at

95See Articles 2 and 3, Bank Indonesia, The implementation of prudential principles in managingexternal debt of the nonbank corporation, Bank Indonesia Regulation Number 16/20/PBI/2014, Oct. 28,2014.

96See paragraph I, Bank Indonesia, Elucidation of Bank of Indonesia Regulation concerning theimplementation of prudential principles in managing non-bank corporate external debt, Oct. 28, 2014.

97This is the prime lending rate in India as of 9th July 2014

3.2 Interventions to regulate foreign borrowing 35

LIBOR rate of 1.70%.98 However, given country risk (India is BBB rated), we need toadd another 2% to the cost of funding99. This means that the firm can access the loan indollar terms at 3.70%. This translates into an interest differential of 6.55%. A foreigncurrency hedge creates a wedge between foreign and domestic interest rates, reducingthe gains from interest rate arbitrage while covering the firm from any unexpectedforeign exchange rate volatility in this period. As long as the cost of hedging is lessthan 6.55%, it is prudent for the corporation to take ECB and hedge its foreign currencyexposure. A foreign exchange hedge can be considered as an insurance and ideally firmsshould calibrate their exposure to their levels of risk appetite. However, internationalexperiences from Brazil, South Korea and South Africa show that firms end up takingexcess foreign currency exposure during a boom period and then suffer the consequencesof excessive risk-taking in a bust period.100 Therefore, firms should be required todemonstrate a plan for hedging their foreign currency exposure, before they can take onforeign currency debt.

3.2.2 Tax

Taxes in theory have similar effect to that of a hedging requirement to a large extent. Atax on foreign currency borrowing introduces a wedge between foreign and domesticinterest rates, reducing the gains from interest rate arbitrage without addressing the riskof currency mismatch arising from foreign currency borrowing. As an example, theFinancial Transactions Tax (IOF) in Brazil was used to reduce the magnitude of shortterm capital inflows coming into Brazil.101 A tax on foreign borrowing, therefore, is aninstrument which reduces the amount of capital inflows by reducing the interest ratearbitrage between domestic and global capital markets. It does not address the problemof currency mismatch associated with foreign currency borrowing. Those firms whoborrow after paying taxes would continue to face exchange rate risk in the absence ofthe obligation to hedge.

3.2.3 Auction

Auctions in theory also work in similar ways to a hedging requirement. The auctionmechanism needs a de jure cap on ECB as a starting point for the bidding process.The theoretical logic of using an auction is that if the Government auctions the rightto borrow abroad, any gains from interest rate arbitrage that a firm may have, will bepared away by a competitive auction process as firms would have to out-bid each otherfor the right to access ECB. An auction mechanism, therefore, serves as a de facto taxand raises the cost of borrowing without reducing systemic risk arising from currencymismatch of firms. It limits the risk by limiting the foreign currency exposure to the cap.Similar to taxes, auctions can only be considered as instrument for reducing systemicrisk if they are used in lock-step with a hedging requirement.

98This is the LIBOR rate in London as of 9th July 201499See, Aswath Damodaran, Equity Risk Premiums (ERP): Determinants, Estimation and Implications–

The 2013 Edition, tech. rep., Stern School of Business, 2013.100See, Jack Ree, Kyoungsoo Yoon, and Hail Park, FX Funding Risks and Exchange Rate Volatility–

Korea’s Case, IMF Working Papers 12-268, International Monetary Fund, Nov. 2012.101See, WTO, OECD, and UNCTAD, see n. 86.


Table 3.1: Comparing various interventions to regulate foreign borrowing

Intervention Cost of borrowing Systemic riskHedging requirement Increased ReducedTax on ECBs Increased Not addressedAuction of ECB rights Increased Not addressed

On balance, both from a theoretical perspective and international experience, ahedging requirement is the least cost method for making foreign currency borrowingless risky.

3.2.4 Other measuresIt may be noted that many countries, in particular emerging economies, use variousmacro-prudential policies to mitigate causes of systemic risk.102

The Committee considered two non-conventional options to mitigate currency risk.First, the borrowers may be asked to put aside an amount equivalent to premium thatthey would otherwise be paying for hedging through derivatives transactions. If thecurrency risk does not actualise, the premium reverts to the borrower. If it actualises, thepremium is used. However, it may be noted that one pays a small premium to hedge abigger likely risk. If the risk actualises, the premium set aside would not be adequate tomeet the risk fully. Second, the borrower may be asked to mark to market its currencyexposure and pay at quarterly set or so the mark-to-market loss to a third party. It may,however, be noted that this would be much more costly as one has to pay the mark-to-market loss fully in comparison to payment of premium for hedging. The first option isnot very effective, while the second option could be costly.

3.3 PrinciplesBased on the analysis above and the preceding chapter, the Committee has distilledcertain principles to guide determination of the ECB framework.

3.3.1 ECB framework should be contemporary1. The ECB framework must be in sync with contemporary economic

thought.2. Ideally, it must serve the economy as a whole, without any sectoral

preference.3. It must address the adverse macro-level potential, if any, of foreign

currency borrowing.

A number of Committees have visited different aspects of ECB and emphasisedcomprehensive review of the framework. The U.K. Sinha Committee Report notedthat there are a number of aspects of ECB policy that require review. These includethe rationale for allowing some sectors but not others, and allowing some types of

102See, Stijin Claessens, Swati R. Ghosh, and Roxana Mihet, Macro-Prudential Policies to MitigateFinancial System Vulnerabilities, IMF Working Papers 14/155, International Monetary Fund, 2014; SouthKorea has used macro-prudential tools to address systemic risk concerns arising out of ECBs. See, C. Kim,“Macroprudential policies in Korea – Key measures and experiences”, in: Financial Stability Review 18(Apr. 2014), pp. 121–130.

3.3 Principles 37

companies but not others, to access ECB. In particular, the reasons for excluding theservices sector, and for restricting banks, housing finance companies, NBFCs and otherfinancial institutions from accessing ECB, may be worth revisiting. The sheer numberof classifications should be minimised and policies between categories harmonised.Similarly, the requirement for foreign equity holders to have at least 25% equity stakesto become eligible lenders under the automatic and approval routes, and the setting oflimits on borrowing, are also topics that are ripe for review. The U.K. Sinha CommitteeReport recommended that ECB policy should be reviewed and formulated with clearprinciples of economic reasoning in mind.

Similarly, the S.S. Tarapore Committee Report recommended that the overall ceilingfor ECB as well as the ceiling under the automatic route should be gradually raised andend-use restrictions should be removed.

The Raghuram Rajan Committee Report, while making a case for modifying theextant framework, noted that lack of predictability of regulations and ceilings on ECBmakes it hard for corporations to plan borrowing, and even to service old loans thatneed to be refinanced. This creates added uncertainty and risk, and drives up the cost offinancing. It advocated a steady liberalisation of constraints on ECB. It recommendedthat the end-use stipulations should be done away with as these hard to monitor.103 Italso recommended that the interest rate spreads should also be liberalised over time.104

Recently, a case was made out for comprehensive review of the regulation relating toforeign exchange transactions.105

Further, H.R. Khan, RBI Deputy Governor, highlighted the adverse potential offoreign currency borrowing. He holds the view that unhedged exposures in respect ofECB or FCCB may lead to large scale currency mismatches in view of the bulk amountborrowed by domestic corporates for longer tenors with limited or no natural hedges.Large scale currency mismatches could pose serious threat to the financial stability incase exchange rate encounters sudden depreciation pressure.106

The recommendations of these experts make out a strong case for review of the extantframework of ECB to simplify the present regulations and improve their predictabilityand neutrality. The framework needs to be reviewed to make it simple, neutral, principlebased, and non-discretionary while addressing the systemic concerns.

3.3.2 Regulations should address market failure1. The market regulations must be informed by an analysis of potential

market failures.2. These financial regulations must be motivated by the objectives of con-

sumer protection, micro-prudential regulation, systemic risk regulationand resolution.

3. Every regulatory prescription must have an explicit rationale statedupfront.

Some markets may fail to produce an efficient allocation of resources, when left tothemselves, an event referred to as ‘market failure’. These arise on account of either

103See, Committee on Financial Sector Reforms, see n. 2, p. 37.104See, ibid., p. 37.105See, Padmanabhan, see n. 2.106See, Khan, see n. 77.


information asymmetry, market power or externalities. When efficient market outcomesare inhibited by market failure, a case is made for regulation.107 Under this approach toregulation, when translated into the field of finance, the task of the Government is clearlydefined by the B.N. Srikrishna Committee Report. The report identifies the followingareas where regulation of financial markets are required:108

1. Consumer protection: A well developed financial system involves complex in-teractions between consumers and financial service providers. At the first level,these interactions require the support of law to define and protect property rightsand facilitate the enforcement of contracts. However, the complexity of financialmarkets and the existence of market failures create the need for a higher standardof protection for financial consumers. The need for financial consumers to betreated fairly makes it appropriate to adopt a more intrusive approach to financialregulation, compared with other fields.

2. Micro-prudential regulation: This is an area of regulation that governs the safetyand soundness of financial firms. The rationale and scope of micro-prudentialregulation are grounded in consumer protection concerns. To some extent, marketdiscipline prevents firms from managing their risks badly, but such discipline isconstrained by information asymmetry and the significant market power enjoyedby financial firms. The State needs to establish regulatory and supervisory mecha-nisms that induce firms to improve their safety and soundness in order to reducethe probability of firm failure, so that firms are able to fulfil the promises theyhave made to consumers.

3. Resolution: Micro-prudential regulations reduce the probability of firm failure.However, eliminating all failure is neither feasible nor desirable. At the sametime, failure of large financial firms can be highly disruptive for householdsthat are customers of the failing firms. This requires a specialised ‘resolutionmechanism’ to ensure orderly resolution of troubled firms before they reach thestage of insolvency.

4. Systemic risk: Micro-prudential regulation addresses the possibility of the collapseof one financial firm at a time. Systemic risk is the risk of a collapse of thefinancial system. An integrated view of the entire financial system is requiredwhen addressing systemic risk concerns. This calls for measurement of systemicrisk, and undertaking interventions at the scale of the entire financial system (notjust one sector) that diminish systemic risk.

Regulation of markets must be informed by an analysis of market failures, and mustseek to accurately target and correct those failures and do no more. The most criticalmarket failure associated with ECB is externalities arising from systemic risk on accountof currency exposure. Another systemic concern associated with ECB is volatility in risktolerance of global investors. Section 3.3.3 applies this approach to regulation makingin the field of ECB.

It is very important that stakeholders must know why a particular prescription isbeing made - whether it is made to stem exchange rate fluctuations, promote a particular

107See Chapter 5, Stan Wallis, Financial System Inquiry Final Report, tech. rep., Australian Treasury,1997.

108See, Financial Sector Legislative Reforms Commission, Report of the Financial Sector LegislativeReforms Commission, tech. rep., Government of India, 2013.

3.3 Principles 39

sector/end-use of the economy, safeguard the integrity of the banking system, addressmarket failure or any other. Every regulation must state the objectives that it endeavoursto achieve. The Supreme Court observed in Daiichi Sankyo v. Jayaram Chigurupati:109

Regulations are brought in and later subjected to amendments without beingpreceded by any reports of any expert committees. Now that we have moreand more of the regulatory regime where highly important and complex andspecialised spheres of human activity are governed by regulatory mecha-nisms framed under delegated legislation it is high time to change the oldpractice and to add at the beginning the ‘object and purpose’ clause to thedelegated legislations as in the case of the primary legislations.

3.3.3 Regulations should be informed by analysis of systemic risk1. The currency risk inherent in foreign currency borrowing has potential

to trigger systemic risk.2. Regulations need to address the currency risk, which is best done by

hedging.3. Regulations need to address the moral hazard and incomplete markets,

which prevent firms from effectively managing currency risk even ifthey wish to.

Of the four concerns identified by the B.N. Srikrishna Committee Report that justifyregulatory intervention, systemic risk is the one most closely connected to the frame-work regulating foreign currency borrowing. Contemporary policy thinking is indeedgeared towards addressing the systemic risk concerns emanating from foreign currencyborrowing in the event of adverse exchange rate fluctuations.

When a company borrows in foreign currency it takes the risk of incurring a currencymismatch on its balance sheet. Specifically, firms make a risk-return tradeoff betweenthe benefits of lower foreign borrowing costs and a probable increase in financial riskdue to exchange rate uncertainty. This can happen due to the firm having receivablesonly in local currency and debt liabilities in foreign currency.

The economic literature associated with foreign currency debt describes two specificreasons for firms taking up excessive foreign currency risk on their balance sheets:

• Moral hazards; and• Incomplete markets.

Moral hazardThere is some consensus in the academic community around the fact that managedexchange rate regimes contributes to the creation of a moral hazard: a pegged exchangerate regime constitutes an implicit guarantee given by Government, and this encouragesfirms to take on excessive foreign currency debt. This leaves firms vulnerable to a suddendepreciation of their domestic currency.

Drawing on a comprehensive database spanning 1,800 non-financial companiescovering six Latin American countries for the period 1992-2005, a recent research foundstrong evidence of a persistent decline in firms’ foreign currency borrowing in response

109See, Supreme Court of India, see n. 60.


to the adoption of a flexible exchange rate regime. The study found that switching toa flexible regime reduced corporate debt dollarisation by 7% on average compared topegged regimes. The study also found that after countries switch to flexible exchangerate regimes, firms with lower natural hedging mechanisms experienced larger declinesin dollar debt relative to firms that rely principally on export revenues or have largedollar asset holding.110

Using a firm level balance sheet database, another study found that active reserveaccumulation by the central bank acts as a public demonstration of a commitment toexchange rate stability. Such de facto insurance induces firms from EMEs, which haveborrowings in foreign currencies, to perceive that they are implicitly insured againstcurrency fluctuations.111 This is a globally persistent phenomenon across EMEs withmanaged exchange rates, as similar evidence has been found for firms in Mexico,112

Chile,113 Asia,114 and India.115

India has now been a floating exchange rate regime for the last 7 years and theaverage volatility of the exchange rate has tripled since 2000.116 Firms have startedlearning how to manage their foreign exchange risk in such a dynamic environment,but there is always an implicit assumption that RBI will protect the Rupee from alarge depreciation as evidenced in the Rupee defence measures of last year.117 Box3.2 outlines the liquidity tightening measures undertaken by RBI and the steps towardsreversal of these measures.

Figure 3.1 shows the trajectory of the interest rate in response to rupee defencemeasures. It shows a sharp hike in interest rates from mid-July to mid-August of 2013when the rupee defence measures were in place. The gradual reversal of these measuresled to lowering of interest rates.

When an interest rate defence is mounted, this adversely affects local currencyborrowers and benefits foreign currency borrowers. The anticipation that RBI willcarry out such interventions generates incentives for firms to avoid local currencyborrowing and favours foreign currency borrowing, and to leave it unhedged againstlarge fluctuations.

Moral hazard may also be caused by an expectation of a bail-out by the Government.Even though there is no direct guarantee of a bail-out for ECB borrowing firms during

110See, Herman Kamil, How Do Exchange Rate Regimes Affect Firms’ Incentives to Hedge CurrencyRisk? Micro Evidence for Latin America, IMF Working Papers 12/69, International Monetary Fund, 2012.

111See, Sengupta, see n. 90.112See, Lorenza Martinez and Alejandro Werner, “The exchange rate regime and the currency composi-

tion of corporate debt: the Mexican experience”, in: Journal of Development Economics 69.2 (Dec. 2002),pp. 315–334.

113See, Kevin Cowan, Erwin Hansen, and Luis Oscar Herrera, Currency Mismatches, Balance-SheetEffects and Hedging in Chilean Non-Financial Corporations, Research Department Publications, Inter-American Development Bank, Research Department, 2005.

114See, David C. Parsley and Helen A. Popper, “Exchange rate pegs and foreign exchange exposure inEast and South East Asia”, in: Journal of International Money and Finance 25.6 (Oct. 2006), pp. 992–1009.

115See, Patnaik and Shah, “Does the currency regime shape unhedged currency exposure?”, see n. 89.116See, Ila Patnaik et al., “The exchange rate regime in Asia: From crisis to crisis”, in: International

Review of Economics & Finance 20.1 (Jan. 2011), pp. 32–43, pp. 32-43.117The term ‘Rupee defence’ is used to denote the liquidity-tightening measures taken by RBI to address

the depreciation of rupee in July-August 2013.

3.3 Principles 41

Jun Jul Aug Sep Oct Nov

89

1011

per

cent

15 Jul '13 25 Jul '13 20 Sep '13 07 Oct '13 29 Oct '13

Figure 3.1: The fallout of rupee defence measures: Sharp hike in interest rates

an adverse currency depreciation, firms implicitly expect that the Government will back-stop losses and prevent bankruptcy given the real economy consequences of reducedoutput and employment through large firm failures. This creates perverse incentives forlarge firms to take on additional foreign currency debt even when they are already athigh levels of leverage. This implicit sovereign guarantee may also be reflected in lowercosts of borrowing for firms that are perceived to be close to the Government or ‘too bigto fail’. This further exacerbates the issue of moral hazard. Government may counter-actthis moral hazard by advocating a clear ‘no bail-out’ policy for firms which have takenon excessive foreign currency risk.

Incomplete marketsA second strand of literature argues that the reason why firms take up excessive currencyrisk is deeper than just moral hazard caused by a managed exchange rate regime. Firms’currency mismatches arise out of incomplete markets. This is grounded in the capitalaccount framework, which prevents firms from hedging their foreign exchange risksand interest rate risks through derivatives. Research shows that use of derivativessignificantly decreases the firms’ exchange rate exposure on a sample of S&P 500non-financial firms.118 Firms may have the technical ability to hedge, but are forced totake on unhedged currency borrowing as the markets for hedging are not available, andif available, are inefficient and costly.

Mr. Padmanabhan contends with this observation and the analysis that follows inthis section. He is of the view that these measures were taken to defend the currencyfrom a run-away depreciating trend which is a systemic issue. In such situations, otherissues flagged are often inconsequential.

The Indian currency derivatives market is subject to an array of controls. While it isappreciated that a series of modifications to the regulatory framework were announcedon July 8, 2013 as part of the Rupee defence, it caused damage to the currency deriva-tives market. Figure 3.2 shows that impact cost on the currency futures market, for a

118See, George Allayannis and Eli Ofek, “Exchange rate exposure, hedging, and the use of foreigncurrency derivatives”, in: Journal of international money and finance 20.2 (2001), pp. 273–296.


Box 3.2: Liquidity tightening measures as part of rupee defence

July 15, 2013: RBI put in place measures in response to the pressure on therupee to depreciate. These included raising the Marginal Standing Facility (MSF)rate by 200 bps to 10.25%, restricting the overall access by way of repos underthe Liquidity Adjustment Facility (LAF) to Rs.750 billion and undertaking openmarket sales of government securities of Rs.25 billion on July 18, 2013.

July 23, 2013: RBI modified the liquidity tightening measures by regulatingaccess to LAF by way of repos at each individual bank level and restricting it to0.5% of the bank’s own Net Demand and Time Liability (NDTL). This measurecame into effect from July 24, 2013. The Cash Reserve Ratio (CRR), whichbanks have to maintain on a fortnightly average basis subject to a daily minimumrequirement of 70%, was modified to require banks to maintain a daily minimumof 99% of the requirement.

August 8, 2013: RBI augmented its measures to tighten liquidity by announcingthe decision to auction government cash management bills for a notifiedamount of Rs.220 billion once every week. It began a calibrated withdrawalof the exceptional measures undertaken since July 2013. The steps followedsubsequently as mentioned below.

September 20, 2013: RBI reduced the MSF rate by 75 basis points from 10.25%to 9.5% with immediate effect.

September 20, 2013: RBI reduced the minimum daily maintenance of the CRRfrom 99% of the requirement to 95% effective from the fortnight beginningSeptember 21, 2013, while keeping the CRR unchanged at 4.0%.

October 7, 2013: RBI reduced the MSF rate by a further 50 basis points from9.5% to 9.0% with immediate effect.

October 29, 2013: RBI reduced the MSF rate by 25 basis points from 9.0%to 8.75% with immediate effect. With this announcement, the MSF rate wasrecalibrated to 100 basis points above the repo rate.

Source: RBI

3.3 Principles 43

Box 3.3: Restrictions on currency derivatives as part of rupee defence

Margins: Initial and extreme loss margins were increased by 100% of the presentrates for USD - INR contracts in Currency Derivatives.

Client level position limits: The gross open position of a client across allcontracts shall not exceed 6% of the total open interest or 10 million USD,whichever is lower.

Non-bank Trading Member position limits: The gross open position of aTrading Member, who is not a bank, across all contracts shall not exceed 15% ofthe total open interest or 50 million USD whichever is lower.

Note: In a partial roll back, the margins for the USD-INR contracts have beenrestored to the pre July 08, 2013 levels.

transaction of Rs.2,00,000, substantially worsened as a consequence.119

Jun Jul Aug Sep

0.1

0.2

0.5

1.0

2.0

Per

cen

t (lo

g sc

ale)

08 Jul 2013

Figure 3.2: Impact cost on rupee-dollar futures

Less liquid markets are generally more volatile. Thus, as presented in Figure 3.3,rupee volatility went up when policy actions reduced the liquidity of the rupee market.Rupee volatility is measured as the realised volatility on the currency futures market.120

These restrictions in our capital accounts framework have generated a shallow andilliquid currency market. In such a scenario, small events generate substantial pricefluctuations. If lower currency volatility is desired, we must foster a deep and liquidmarket. Higher the volatility, higher is the cost of hedging. ECB would be prohibitivelycostly if the borrowers are required to hedge in a not so deep and liquid currencyderivatives market.

119See, Rajat Tayal, Impact of restrictions on the trading of currency derivatives on market quality,tech. rep., Finance Research Group, Indira Gandhi Institute of Development Research, 2013.

120See, ibid.


Jun Jul Aug Sep

510

1520

Per

cen

t

08 Jul 2013

Figure 3.3: Exchange rate volatility

3.3.4 Regulations should address the concern and do no more1. Regulations must create stable, liquid markets by reducing macroeco-

nomic risks associated with foreign currency borrowing.2. Microeconomic restrictions not connected to mitigation of systemic

risk must be dismantled.3. Policy should support an enabling environment that reduces the need

for intervention on case to case basis.

On the one hand, foreign currency borrowing is important for firms as it augmentstheir financial choices, whereas on the other hand, if the borrowing is unhedged, itcreates systemic risk and adverse exchange rate related feedback loops in the realeconomy. The challenge in the Indian scenario lies in creating a stable foreign currencyborrowing environment wherein access to foreign borrowing is provided to as manyfirms as possible, while being prudent and addressing issues of systemic risk.

The regulatory framework governing foreign currency borrowing should seek toaddress the important market failures that place the financial system at risk. At the sametime, microeconomic restrictions such as restrictions on borrowers, lenders, all-in-costceilings, amount of borrowing, end-use, etc. should be dismantled, wherever doing sodoes not conflict with the objective of reducing systemic risk. The present regulatoryframework, though characterised by several regulatory interventions governing eachaspect of borrowing, fails to address the above market failures.

From a broader perspective, the guiding principle should be one of supporting anenabling environment in which a functioning market reduces the need for interventionon case to case basis. Solving the problem of incomplete markets – in this case theabsence of a functioning currency derivatives market – would allow firms to hedgeagainst foreign currency risk in ways that they are currently unable to do.

4 — Issues and responses

Based on internal deliberations as well as consultations with the stakeholders, theCommittee identified the policy issues relevant to ECB and analysed them in depth,keeping in view the principles of economics, laws and regulations enunciated in earlierchapters. In this chapter, each policy issue is framed as a question, and the Committee’scorresponding recommendations are stated, accompanied by an explanation for the samebased on data analysis, comparative legal study and the guiding principles discussedbefore.

4.1 What should be the objective of the ECB framework?The Committee recommends that the objective of the ECB framework should be to allowIndian firms an effective option to borrow in foreign currency subject to systems in placeto address systemic risks emanating from unhedged foreign currency exposure of a largenumber of firms and volatility in global risk tolerance.

The country needs resources to promote and sustain economic growth. The firmsneed resources at the lowest possible cost to be globally competitive and provide goodsand services at the lower cost to citizenry. The country as well as the firms must haveeffective access to raise resources through all possible sources, including ECB. Anyunwarranted restriction on firms’ access to ECB limits the growth and prosperity of theeconomy unjustifiably.

We seem to be using the ECB framework to pursue a number of objectives simul-taneously. For example, the framework prohibits guarantee by the banks and restrictsborrowing by NBFCs because these entities carry financial stability concerns.121 Besides,the framework promotes certain sectors and end-uses.122 ECB is discouraged to stemappreciation of the rupee and encouraged to stem depreciation of the rupee.123 The

121See Part I. (A) viii, Reserve Bank of India, 2014 Master Circular, see n. 16.122See Part I. (B) i,n ibid.123See, Padmanabhan, see n. 2.

46 Issues and responses

use of an instrument to achieve multiple objectives has adverse consequences.124 Amodification of the instrument can impact different objectives differently. To the extentpossible, one instrument should be used to pursue only one objective. It is desirable touse the ECB framework to address the market failures arising from currency exposure ofnumerous firms that have taken ECB. The prohibition on banks to give guarantee shouldbe handled in the policy related to banks which deals with so many other guarantees.

ECB is not an unmixed blessing. When a firm borrows in foreign currency, itsbalance sheet is exposed to exchange rate fluctuations. Exchange rate depreciation raisesthe value of its net foreign currency denominated liabilities relative to the net presentvalue of its cash flow.125 This puts the firm at a higher risk of failure. However, a firmshould be free to take such risks. They are part of many commercial decisions madeby a firm. The State has no reason to intervene merely because a firm has unhedgedforeign currency exposure. However, if a large number of firms have unhedged foreigncurrency exposure, there can be a correlated failure of numerous firms when a largeexchange rate movement takes place. This correlated failure can adversely affect GDPgrowth and thus impose externalities upon others. Thus, it can be a source of systemicrisk, which motivates State intervention in this field. Contemporary policy thinking isgeared towards addressing such systemic risk concerns. Therefore, the objective of theECB framework should be to guard against the systemic risk emanating from unhedgedforeign currency exposure of a large number of firms, not limiting the amount of ECBeither for a firm, a sector, a purpose or the economy. The other systemic risk could bevolatility in global risk tolerance, which creates huge fluctuations in capital flows onaccount of ECB in rare circumstances. This also needs to be addressed by the ECBframework.

There has been a feeling that when ECB is raised or repaid, it involves flow offoreign currency. This has effect on exchange rate and consequently the domestic prices.While the borrower benefits from ECB, the society suffers from the price fluctuation.Hence it is being suggested in certain circles that the beneficiaries of ECB must bearthe sterilisation cost. This Committee does not subscribe to this view for two reasons.One is that the market finds the equilibrium exchange rate. The net inflow or outflowfrom foreign currency borrowing and repayments is too insignificant given the totalforeign currency transactions in the economy and would not make any difference to theequilibrium market price, particularly if the ECB borrowers are engaged in productionof tradeables. The market absorbs orders from a diverse array of people, and constantlyreshapes the economy based on the changes in prices. This is similar to import or exportwhich causes flow of foreign currency, but the State does not recover sterilisation costfrom every importer or exporter. The second is that the import or export, and also anyborrowing or repayment of the same benefits the economy and the society by makingbetter quality of produce available at lower cost. Hence, no restriction is warranted onaccess to ECB except to the extent required to address the systemic concern.

124See, Gokarn, see n. 61.125See, Eichengreen, Hausmann, and Panizza, see n. 91.

4.2 Who can borrow in foreign currency? 47

4.2 Who can borrow in foreign currency?The Committee recommends that any and every firm may borrow in foreign currencyprovided it hedges a specified percentage of its foreign currency exposure, as specifiedthrough regulations.

The Foreign Exchange Management Act, 1999 governs all aspects of ECB. It allowsECB under two routes, namely, automatic route and approval route. Both the routeshave lists of eligible borrowers. It is hard to find any rationale in the current state ofthe economy for inclusion of a borrower in the list of automatic route while inclusionof another in the list of approval route. Similarly, there is no apparent reason why aborrower is included in the list of eligible borrowers while another is not. And thelists are becoming long over time probably to reflect political economic compulsions.The prospective borrowers are tempted to lobby for their inclusion in the list under theautomatic route or, at least their requests to be considered under the approval route.Thus, the framework favours certain borrowers (sector) and discriminates others andinevitably induces distortion. Being very prescriptive, it imposes huge administrativecosts. As explained earlier, the framework being non-neutral, distortionary, prescriptive,discretionary is unpredictable, and antithetical to the rule of law.

It is observed that ECB was not initially available to borrowers in service sector,probably because then the service sector was not important in the economy and mostof the services were rendered by unorganised sector. Even though the service sectorcontributes more than half of the GDP, most of the services do not have access to ECB.

Under the current economic philosophy, every economic agent must have full free-dom to take economic decisions. For example, every company is eligible to accessdomestic capital market and nobody is ineligible per se. The market regulator has notspecified eligibility criteria for companies or sectors to access the market nor does itcap the raising for different end-uses or impose different obligations. It has laid downuniform norms and everybody meeting the norms and interested to raise resourcesaccesses the capital market. It does not specify how much one can raise and under whatterms. It does not even suggest indicative terms. Hence, there is no case for authoritiesto promote one borrower or sector and discourage another or define the contours of theterms of borrowing. The provision that allows some sectors or borrowers to borrow onthe terms as specified or approved by the authorities is not in sync with current economicthinking.

The Committee has noted earlier that State intervention in the form of regulationsis necessary only to address market failures. The only market failure associated withECB is systemic risk arising from exchange rate fluctuations. Therefore, the eligibilitycriteria, if any, for borrowers of ECB should be designed to minimise potential systemicrisk concerns arising out of exchange rate fluctuations.

Accordingly, the Committee recommends that no one per se should be ineligiblefrom accessing ECB. The borrowers should, however, be under obligation to addressthe risks they are bringing to the system. This means that the policy should encouragehedged foreign currency borrowing. It should specify the percentage of foreign currencyborrowing that needs to be hedged and this percentage should be uniform across sectorsand borrowers. A firm should be allowed to access ECB provided it demonstrates orcommits to hedge - natural or financial - the specified percentage of its foreign exchange


risk while availing ECBs.

4.3 Who can lend in foreign currency?The Committee recommends that a foreign lender who does not have Indian interestshould be allowed to lend in foreign currency. There should be no other restriction onwho can lend in foreign currency.

It is observed from Table 2.10 that the framework recognises certain kinds of lenderseligible to lend ECB. This means that other potential lenders who have the capacityand interest to lend ECB are prohibited to do so. Further, certain kinds of lenders canlend ECB only to certain kinds of borrowers. An eligible borrower cannot borrow ECBfrom any recognised lender and a recognised lender cannot lend ECB to any borrower.Strange as it may seem, a regional financial institution cannot lend to a MFI but canlend to a NBFC-MFI. Similarly, an export credit agency cannot lend to NBFC-MFIbut can lend to a MFI. There is no rationale evident for such prescriptions, which donot address any market failure. It rather limits the choice of economic agents withoutany corresponding gain. Further, it results in over-use of certain lenders and under-useof certain others. Every foreigner should be eligible to lend ECB to every borrowerirrespective of end use.

The concerns of money laundering are real. Therefore, the lender must be from aFATF compliant jurisdiction which is under legal obligations to share information andcooperate with the Indian authorities in the event of any investigation.

Foreign currency borrowings expose the domestic borrowers to currency risk. Ifsuch a borrowing is extended by a domestic lender, the credit default risk also getsaccentuated domestically instead of being diversified internationally. This aggravatessystemic risk and consequently, the possibility of a market failure. To illustrate, consideran Indian bank having a branch in London. The London branch lends GBP 1 millionto an Indian firm based in Mumbai at GBP 1 = Rs.100. So the Indian firm has a rupeeliability of Rs.100 million. Assume that the value of rupees subsequently depreciatesagainst the pound to GBP 1 = Rs.200. Now the Indian firm’s rupee liability doublesto Rs.200 million. If due to this increased rupee liability, the Indian firm defaults inpayment of the loan, the parent Indian bank would be affected. In other words, thedefault risk due to exchange rate fluctuation gets concentrated in the domestic bankingsystem. Instead, had the Indian firm taken the GBP 1 million loan from a foreign bank inLondon (without any Indian interests), then its default risk due to depreciation of rupeeagainst GBP would have been diversified internationally, and not affected the domesticIndian banking system. So if both the lender and borrower are domestic and the loan isdenominated in a foreign currency, the systemic risk concerns are aggravated.

The extant regulations recognise this risk. Consequently, Indian banks and NBFCsare prohibited from providing guarantees or letter of credit, in relation to ECBs.126

This requirement acts as a prudential safeguard governing bank lending. Anotherprudential safeguard prohibits companies from raising ECB from subsidiaries of Indianbanks overseas to refinance rupee loans.127 Subsequently, the prohibition on lending

126See Part I. (A) viii, Reserve Bank of India, 2014 Master Circular, see n. 16.127See, Reserve Bank of India, Fund/Non-Fund based Credit Facilities to Overseas Joint Ventures /

4.4 Should the amount of ECB be regulated? 49

by overseas branches or subsidiaries of Indian banks was extended to some other end-uses.128

The Committee noted the recent experience of the emerging European economieswhere large scale unhedged foreign currency lending by banks contributed to soaringnon-performing assets and contributed to aggregate systemic risk.129

The Committee, therefore, recommends that recognised lenders should not haveany Indian interests. This implies that domestic Indian banks, along with their overseasbranches and subsidiaries of banks incorporated in India, should not be recognised aslenders under the ECB framework. This requirement will ensure that Indian banks arenot exposed to exchange rate risk through default risk. This is also in consonance withRBI’s policy to wall off the Indian banking sector from foreign currency borrowing byIndian firms.

4.4 Should the amount of ECB be regulated?The Committee recommends that the extant restrictions on the maximum permissibleamount should be done away with. The ability to hedge should determine the amount ofborrowing.

The extant framework specifies the maximum amount that can be borrowed. Thereare limits on the amount that can be borrowed by an individual borrower, which variesfrom sector to sector and end-use to end-use, and by borrowers in aggregate in a sector.ECB beyond the permissible amounts under the automatic route are considered underthe approval route.130 There is also a soft cap on the aggregate ECB for the economyin a year. These firms, sector or economy level limits on ECB make the law undulycomplicated and limit the freedom of economic agents without any overt rationale.These do not address any identified market failure associated with foreign currencyborrowing - the correlated failure of a large number of firms who have taken ECB. Aslong as a significant portion of ECB is not hedged, limits on the amount of firm levelborrowing is not of any help. A firm borrowing foreign currency within the prescribedlimit is still exposed to currency risk. It can be argued that the limit can be adjusted tokeep this unhedged exposure at a manageable level. But prior experience with the extantframework shows the practical difficulties of imposing and adjusting such limits. Therequirement to hedge addresses the market failure by minimal intervention into a firm’scommercial freedom.

The Committee is of the view that the ability to hedge - natural or financial - aprescribed percentage of borrowing should determine the amount of the ECB. Thereshould be no limit on amount of borrowing by a borrower or a sector. The prescribedpercentage of hedge should be uniform and could be modified depending on the ex-

Wholly Owned Subsidiaries / Wholly owned Step-down Subsidiaries of Indian Companies, RBI/2013-14/568 DBOD.No.BP.BC.107/21.04.048/2013-14, Apr. 22, 2014.

128See, Reserve Bank of India, External Commercial Borrowings (ECB) Policy - Refinance / Repaymentof Rupee loans raised from domestic banking system, RBI/2013-14/585 A.P. (DIR Series) Circular No.129,May 9, 2014.

129See, Romain Ranciere, Aaron Tornell, and Athanasios Vamvakidis, A New Index of CurrencyMismatch and Systemic Risk, IMF Working Papers 10/263, International Monetary Fund, Nov. 2010.

130See Part I(I)(B)(iii), Reserve Bank of India, 2014 Master Circular, see n. 16.


igencies. However, the Committee recommends continuation of the aggregate “softcap” on ECB inflows in a year, as currently set by HLCECB, to mitigate volatility anduncertainty in ECB inflows. This cap would not be in policy or regulation, but couldguide the authorities in modifying the hedge ratio.

4.5 Should the maturity structure be regulated?The Committee recommends that the extant prescriptions relating to maturity structureshould be done away with. The maturity pattern of foreign borrowing should be left tothe market.

Firms take commercial decisions, including ECB. It is a contractual relationshipbetween the lender and the borrower. The State has no reason to worry or intervene ifone borrows for three years or seven years as there is no potential market failure. TheCommittee notes that though ECB is generally allowed for maturities above three years,ECB for shorter duration (bridge loan) is permitted under the approval route.

The Committee is of the view that the maturity structure of foreign currency bor-rowing should be determined by market forces, as the maturity of any debt in domesticmarket. Regulating maturity structure unduly curtails a firm’s ability to take commercialdecisions. It may even harm a firm. For example, a firm needs ECB of US 20 million forthree years and it can get it at 2% while the cost of domestic borrowing is 10%. However,the ECB framework forces it to take ECB for a minimum maturity of five years. In sucha case, it does not avail ECB and avails a high cost domestic loan. Further, a higherminimum maturity makes it difficult for a firm to hedge the currency exposure. Oftenthe market does not have products to enable hedging for five years or seven years. In thatcase, one incurs greater roll-over risk. In view of the above, the Committee recommendsthat the maturity restriction should be done away with.

Mr. G. Padmanabhan, a member of the Committee, is of the view that given thatcross-border lending can be irrationally exuberant, some mild restrictions in the form ofmaturity are warranted. Too much of short term debt can have stability implications.

4.6 Should the cost of borrowing be regulated?The Committee recommends that the extant prescription relating to cost of borrowingshould be done away with. The invisible hands of market should determine the cost.

Under the extant regulations, the permissible all-in-costs are expressed as ceilingsover 6-month LIBOR for the respective currency of borrowing or applicable bench-mark.131 It includes rate of interest, other fees and expenses in foreign currency exceptcommitment fee, pre-payment fee, and fees payable in Indian Rupees. The Committeenotes that the ceiling on cost of ECB does not address any market failure. Rather it mayset the floor at which the lender is willing to lend to Indian borrowers and increase thecost of borrowing in case of AAA borrowers.

Just like myriad other commercial decisions made by firms, cost of borrowing is amatter of contractual relationship between the parties. It is for the lender to assess the

131See Part (I) (I)(A)(iv), Reserve Bank of India, 2014 Master Circular, see n. 16.

4.7 Should end-uses of ECB be regulated? 51

default risk of the borrowing firm. If after examining the borrower’s profile, the lenderis willing to risk lending at a particular rate of interest and the borrower agrees to takeup the liability, their contractual freedom must prevail. The State has no reason to worryor intervene. Domestically, coupon rate or interest rate is market-determined. It is alsomarket determined internationally. There is no reason why the same principle shouldnot apply to ECB. The Raghuram Rajan Committee Report, while making a case formodifying the extant framework, recommended that the interest rate spreads should beliberalised over time.132

Mr. G. Padmanabhan, a member of this Committee, is of the view that the all-in-costceiling is useful in excluding the worst borrowers from taking ECBs. It also helps thelender to appraise the borrower’s proposal with due care. However, if the ceilings are notin tune with the market conditions, it may signal to the lender that the Indian borroweris prepared to pay higher than the market rates.

4.7 Should end-uses of ECB be regulated?The Committee recommends that there should be no restriction on end-use of proceedsof ECB as it does not address any market failure. ECB should be allowed for everyend-use other than those in the negative list under the FDI policy.

The Committee notes that the extant framework stipulates a list of permissible end-uses. In addition, it expressly prohibits certain end-uses. However, the policy has beenundergoing changes over the years. The end-uses that were not allowed under the initialpolicy regime have slowly been permitted. The proportion of borrowing for onward orsub-lending, refinancing of old loans and working capital requirements, which were notallowed earlier, has increased over time. However, these policy changes expanding thescope of end-uses do not seem to follow any economic rationale relevant today. Forexample, ECB is not permitted under the approval route for general corporate purposes,including working capital. However, ECB for working capital in civil aviation sector ispermitted under the approval route.133 Again, infrastructure firms are allowed to utiliseonly 25% of the ECB proceeds towards refinancing of rupee loans, while firms in thepower sector can use 40% of ECB towards refinancing of rupee loans. These are a fewexamples of sectoral bias in end-use requirements devoid of any logic relevant today.Occasionally, the end-use regulations have had unintended consequences. Internationalexperience does not provide any evidence on the effectiveness of end-use restrictions.Besides, such restrictions do not address any market failure. In any case, money beingfungible, it is hard to monitor compliance with end-use requirements. In fact, boththe Raghuram Rajan Committee Report and S.S. Tarapore Committee Report haverecommended that end-use restrictions should be removed.

Domestically, a company can raise resources - equity or debt - without any obligationto put the resources to a particular end-use. It may have obligation to disclose the end-useof the proceeds, but it is not prohibited from raising resources for any particular end use.Similarly, there is no restriction on a company to raise resources from abroad. If foreigninvestment is permissible in a sector, ECB should also be available for that end-use. This

132See, Committee on Financial Sector Reforms, see n. 2, p. 37.133See, Reserve Bank of India, 2012, see n. 65.


means that ECB should be treated at par with FDI as regards end-use is concerned. Theregulations may prescribe that the negative list for FDI would constitute the negative listfor ECB.

Some end-uses create a natural hedge for foreign currency exposure while someothers do not. Different end-uses generate different levels of natural hedge. The require-ment of a particular hedge ratio would encourage borrowing for end-uses generating asubstantial natural hedge and discourage borrowering for end-uses having no potentialfor natural hedge, unless the borrower is willing to hedge the currency exposure throughderivatives positions.

4.8 Should an ECB transaction require approval?The Committee recommends that no borrowing should require any approval.

As observed in section 2.3.4, the approval route of ECB under the extant regulatoryframework is riddled with complexity, opacity, unpredictability, and discretion. There isno economic clarity on the choice of entities allowed to avail ECB under the approvalroute. There is also no legal clarity on the process governing approvals. In any case,such approvals do not address any identified market failure.

As stated earlier, India along with the rest of the world has moved away from therequirement of approval for any transaction by an economic agent. For example, Indiamade a clear departure from merit based regulation when it repealed the Capital Issues(Control) Act, 1947 in 1992 and did away with the requirement of any approval from anyauthority to access capital market. The terms of access were left to be determined bymarket forces. The requirement of approval for any transaction takes the country backby two decades to a command and control regime.

The Committee is of the view that a firm must not require any approval for undertak-ing ECB. Mr. G. Padmanabhan, a member of the Committee, is, however, of the viewthat ECB beyond USD 1 billion by a borrower in a year should require approval as wemove on the path of liberalisation to mitigate extreme volatility in ECB flows.

If for any reason the authorities consider it absolutely necessary to require approvalfor borrowing beyond a threshold, say x% of GDP, the approval must follow an objective,transparent process. The process of applying for ECB under the approval route andthe process for consideration of the application must be specified up front throughregulations. The approval process must be subject to strict time-lines. If an applicationunder the approval route is not specifically rejected within 30 days, the applicationshould be deemed approved. In case of rejection of an application, the aggrieved partiesmust be heard and a reasoned order must be given in a structured format. Such ordersmust be made freely and publicly accessible and also appeal should lie to the SecuritiesAppellate Tribunal (SAT). This would develop a rich jurisprudence around the processof granting approvals and improve predictability.

4.9 Should there be a special dispensation for PSUs?The Committee recommends complete sector or use neutrality in application of theframework governing ECB.

4.10 Should there be a special dispensation for infrastructure? 53

ECB is a commercial loan. Every commercial entity should have equal access to it.In fact, it has been a consistent policy of the recent years to allow the same level playingfield to all economic agents, whether in public sector or private sector, engaged insimilar activity. For example, every company, whether in private or public sector, has tocomply with corporate governance norms under the Companies Act, 2013 and the SEBIregulations. The only market failure associated with unhedged foreign currency exposuredoes not discriminate between Public Sector Undertakings (PSUs) and other borrowersof foreign exchange. PSUs taking ECB are as vulnerable to currency mismatch as anyother Indian firm borrowing in foreign exchange and consequently, the systemic riskconcerns are the same.

A few members of the Committee were inclined for a favourable treatment towardsPSUs. However, the majority was of the view that there should be a level playing field inthe application of the framework governing ECB. Regulations should apply uniformlyto public and private sector entities. First, the PSUs are in a better position to raise ECBfrom market in view of the implicit sovereign guarantee they enjoy. Second, a specialdispensation to PSUs will provide incentives for PSU companies to take on excessivecurrency risk. Third, if a large PSU fails, it aggravates systemic risk concerns andmay have large fiscal consequences. Vulnerable to problems of political economy andlobbying by interested parties, Government may be compelled to bail out the PSU. Thismoral hazard problem would further encourage such PSUs to take on further excessivecurrency risks. This is all the more reason to not extend any special dispensation toPSUs under the ECB framework, which should be completely ownership neutral in itsapplication.

4.10 Should there be a special dispensation for infrastructure?The Committee recommends complete sector or use neutrality in application of theframework governing ECB.

A critical challenge facing Indian policy makers is to garner investment into infras-tructure. The traditional sources of financing, namely bank financing and bond market,are inadequate to meet such a huge demand. Banks face regulatory constraints, such asexposure limits to groups as well as sectors, to prevent the build-up of asset-liabilitymismatch in the system. And the domestic bond market is in a nascent stage and cannotprovide adequate financing. Therefore, the ability to meet the investment needs ofinfrastructure critically depends on finding alternate sources of funding. ECB can playan important role in supporting infrastructure financing in the economy and consequentlyoverall growth. Though infrastructure may not generate a natural hedge, it spurs manyactivities which generate natural hedges for the economy. Therefore, some membersof the Committee were of the view that the norms governing ECB should be liberalfor infrastructure firms. These firms may be required to have a lower hedging ratioin comparison to other firms accessing ECB. However, this ratio should be uniformirrespective of the kind of infrastructure.

After detailed deliberations, the Committee took a view that domestic infrastructurefirms generate revenues only in rupees. Exposure of such firms to currency mismatch


have higher systemic risk concerns. Hence, domestic infrastructure firms should not begiven any special dispensation under the ECB framework.

The Committee, however, recognises that infrastructure needs funding from allpossible sources. The authorities must endeavour to make other alternative sources offunding available for infrastructure. In particular, the pension and insurance companiesshould be allowed and encouraged to make investment in infrastructure.134

4.11 How can systemic concerns arising from ECB be addressed?The Committee recommends that the firms accessing ECB must demonstrate hedging ofa specified percentage of currency exposure arising from the ECB.

An Indian firm borrowing in foreign currency is exposed to currency risk. If a largenumber of firms have unhedged foreign currency exposure, there can be a correlatedfailure of numerous firms when a large exchange rate movement takes place. Thiscorrelated failure can depress GDP growth and thus impose externalities upon citizenry.This has implications on financial stability135 and motivates State intervention. Although,till date, this has not culminated into any major crisis, the recommendations of thisCommittee are forward looking. The Committee recognises that there could be asystemic concern in terms of huge fluctuations in ECB flows arising from volatility inglobal risk tolerance. The thrust, therefore, is on developing a liberalised, yet prudentframework of foreign borrowing, wherein the possibility of systemic risk arising fromcurrency mismatch of firms and global risk tolerance is addressed.

These concerns are most conveniently addressed by hedging, natural or throughcurrency derivatives. The Committee observes that in October 2014, Indonesia imposedmandatory hedging requirements for non-bank corporations holding external debt inforeign currency.136 Bank Indonesia was motivated to issue this regulation to avertpotential adverse effects to the Indonesian economy, as had occurred during the 1997-1998 crisis, due to spiralling private external foreign currency debt.137

The Committee observes that the ECB framework did not mandatorily requirefirms taking ECB to demonstrate hedging or actually hedge their currency exposure.On realising the potential systemic risk inherent in unhedged currency exposure, theauthorities of late have started prescribing hedging for some borrowers. For example,ECB by NGOs engaged in micro-finance activities and MFIs, NBFC-MFIs, IFCs, HFCsand SIDBI are required to hedge the currency exposure to a specified extent. However,the share of these borrowers in total ECB is insignificant. It is observed from Table 2.11and 2.12 that around 50% of the ECB borrowing firms, which constitute over 70% ofthe ECB amount borrowed in a year, are in need of financial hedging to cover their risksarising out of foreign currency borrowing. It is also observed that the hedge ratio forECB/FCCB declined sharply from about 34% in 2013-14 to 24% during April-August,2014 with very low ratio of about 15% in July-August 2014.138

134See, Ministry of Finance, Report of the Committee on Investment Norms for Insurance and PensionFunds, tech. rep., 2013.

135See, Khan, see n. 77.136See Articles 2 and 3, BI, Bank Indonesia’s Prudential Principles, see n. 95.137See paragraph I, BI, Bank Indonesia’s Elucidation, see n. 96.138See, Khan, see n. 77.

4.12 What are the prerequisites for the revised framework? 55

The Committee deliberated on the issue of measurement of unhedged currencyexposure of firms. Exports, imports and foreign borrowing are not the only ways inwhich a firm may be exposed to currency risk. Any firm that deals with ‘tradeables’ isexposed to currency fluctuations. The key insight is that things that can be traded acrossthe border have ‘import parity pricing’: the Indian price is just the world price multipliedby the exchange rate. A firm that purchases tradeable raw materials (that tantamountsto importing raw materials) and sells tradeable output (that tantamounts to exportingfinished goods) has an exposure that is equivalent to the price of the output net of theraw material cost. This is the net unhedged exposure owing to the business of the firm.Adding the exposure owing to foreign currency borrowing provides the overall pictureof the exchange rate exposure of the firm. Thus the measurement of currency exposureowing to the business of a firm must be based on the concept of import parity pricing.139

Firms structure their hedging transactions keeping in view their entire portfolio. Whilethe regulator should prescribe the proportion of foreign currency exposure that should behedged, firms should have the flexibility to determine their hedging strategies based ontheir risk-return trade-off. Hedging is an agent’s choice depending on her risk appetite.

The Committee recommends hedging a specified uniform percentage of ECB takenby any borrower. The hedging ratio could be determined and modified, taking intoaccount the financing needs of the Indian economy, the development of the onshorecurrency derivative market and the volatility in risk tolerance of global investors. Sincehedging becomes the main lever of the ECB policy, it is necessary to review the extantarrangement for monitoring of hedging and, if required, strengthen the same.

As discussed in sections 3.2.2 and 3.2.3, tax and auctions have the effect of raisingthe cost of borrowing and thereby limiting the ECB transactions and earning revenuefor the exchequer. These would unnecessarily limit the availability of international debtcapital much required for the growth, without addressing the market failure associatedwith such borrowing. Therefore, the Committee does not recommend any such measure.

According to Mr. Padmanabhan, a member of the Committee, foreign currencydebt does not become an unmixed blessing merely because it is hedged. The total riskcontacted by the system will have to be managed within the system and this is alwaysa challenge for emerging economies like India where markets are not fully developed.Further, in his view, mandated hedging is not the best way forward, one rule fits alldoes not work well in practice, and it is difficult to implement and monitor. Hence, hebelieves that the implementation of this recommendation, if accepted, will have to becarefully calibrated.

Mr. Ravindran, a member of the Committee, believes that swings in risk tolerancelevels and capital flows can have significant impact on domestic liquidity conditions,overall macroeconomic and financial stability with significant bearing also on the capitalmarket. Therefore, necessary tools should be available under the ECB framework toaddress systemic risk which may impact capital markets.

4.12 What are the prerequisites for the revised framework?Though a well developed on-shore currency derivatives market and a well-developedrupee denominated domestic debt market are useful building blocks of the revised ECB

139See section 3.1.1.


Box 4.1: Reform strategy in Brazil

Brazil has laid emphasis on the development of sophisticated financial markets. Akey principle governing the financial regulatory policy has been to accord equaltreatment to domestic and international investors. Deepening of the process offinancial opening began in January 2000, when Resolution CMN n. 2689 allowedunrestricted access for non-resident (i.e., foreign) investors to all segments of thedomestic financial market, including the derivatives market (where since 1995they had been limited to operations to cover their positions in spot markets). Allkinds of entrance taxes, minimum stay periods, etc. were abandoned, as domesticand international investors were guaranteed equal treatment.

The complete opening of derivatives market has fostered the liquidity and depthof the foreign exchange futures market, strengthening the transmission channelsbetween the investors’ portfolio decisions, the interest rate, and the nominalexchange rate.

policy, the Committee recommends that the hedge ratio should factor in the level ofdevelopment of these markets.

The macroeconomic and financial instability in emerging markets following thecrises of the late 1990s has largely been associated with currency mismatches arisingdue to excessive foreign currency denominated borrowing. These incidents motivatedpolicy reforms to mitigate currency risks associated with foreign currency borrowing.Over time, two distinct strands of thought have emerged in this regard:

• Strengthen the on-shore currency derivatives market to encourage hedging offoreign exchange borrowing to reduce currency risk and/or allow firms to hedgeoverseas;

• Develop local currency denominated bond markets as an alternative source of debtfinancing for public and private sectors.

The Committee is of the view that both these strategies have important bearing onmoving to the revised ECB framework and also lessons for Indian policy makers.

4.12.1 Strengthen the currency derivatives market

Currency derivatives allow borrowers of foreign currencies to hedge against unexpectedexchange rate fluctuations. They act as a kind of insurance against exposure to currencyrisk. The development of sophisticated onshore currency derivatives market is thekey to the establishment of a robust framework of foreign currency borrowing. Box4.1 outlines the reform strategy in Brazil towards the development of a sophisticatedcurrency derivatives market. The Committee is of the view that the Brazilian experiencein this regard is helpful to understand the policy and regulatory reforms necessary tostrengthen hedging markets in India.

Though the Committee recommends that the ECB policy should encourage hedgingof foreign currency borrowing, it is aware that presently in India, even if a firm is sensibleand wants to hedge its foreign currency exposure, adequate infrastructure for hedging is


not available. This lack of infrastructure is at two levels: first, limited choice of hedginginstruments are available to Indian borrowers; second, the high cost of hedging makes itunattractive.

Limited choice of hedging instrumentsThe framework allows various structured products to hedge exchange rate risk arising outof current and capital account transactions in the OTC market.140 These include, amongothers, interest rate swap, cross-currency swap, coupon swap, cross-currency option,and forward rate agreement. Exchange traded currency derivatives were introduced withcurrency futures in 2008 and currency options in 2010. These were highly restrictedproducts at the time. Policy makers argued that as experience built up, the restrictionswould be gradually eased.141 However, since December 2011, a number of policy actionswere taken that restricted the freedom of persons to hedge their currency risk, both inthe OTC market and in the exchange based system.142 These measures have limited thechoice of hedging instruments available to Indian firms seeking to raise ECBs.

The Committee is of the view that it is necessary to introduce a varied range ofoptions, which will enable the market participants to optimise their hedging strategy.143

Till that is done, the Committee is not in favour of recommending complete hedging. Assuch, the intent of the Committee’s recommendation on hedging is to guard the firmsagainst adverse exchange rate fluctuations and not to intervene in their business modelsand decisions. Accordingly, the Committee recommends that the restrictive measuresimposed on OTC as well as exchange traded currency derivatives should be reversed.And, the policy framework governing these currency derivatives need to be reformedwith the objective of providing adequate hedging avenues to the market participants.

Excessive cost of hedgingA borrower needs to factor in the cost of hedging while making a decision to borrowin foreign currency. The cost of hedging transactions is determined by the forwardpremium considered while arriving at the exchange rate for repayment in future onpre-set dates. The cost of hedging also depends on the mode of hedging. The mostcommonly used forms of hedging involve the use of forwards and exchange tradedfutures which lock in the dollar rate for a future payment date. The cost of forwards orfutures at any time horizon depends on future expectations of how the rupee is expectedto move. Today markets in India are underdeveloped and the cost of hedging rangesfrom 3-4% during normal times. The cost of hedging went up to 6-7% during the rupeedepreciation from May to August, 2013.144 This makes hedging unattractive to theborrower since it reduces the cost advantage of foreign currency borrowing vis-a-visdomestic borrowing.

140See, Reserve Bank of India, Comprehensive Guidelines on Over the Counter (OTC) Foreign ExchangeDerivatives and Overseas Hedging of Commodity Price and Freight Risks, Dec. 28, 2010.

141See, Reserve Bank of India, Guidelines on trading of Currency Futures in Recognised Stock / NewExchanges, Aug. 6, 2008.

142For an analysis of the recent measures See, SEBI, Revised Position Limits for Exchange TradedCurrency Derivatives, CIR/MRD/DP/22/2013, July 8, 2013.

143See, Padmanabhan, see n. 2.144See, Reserve Bank of India, Handbook of Statistics on the Indian Economy: Table 206, URL:

http://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications (visited on 12/10/2014).


If the currency derivatives market is liquid, even when the exchange rate is volatile,the bid-ask spreads in the exchange derivatives markets will be low allowing for low costhedging. This will induce more firms to adopt hedging strategies without a substantialincrease in borrowing costs.

RecommendationsThe Committee notes that the Union Budget for 2014 has proposed to advise financialsector regulators to take early steps to deepen the currency derivative markets by elim-inating unnecessary restrictions.145 It has not done an in-depth work to recommendmeasures necessary for this purpose. The authorities may, inter alia, consider thefollowing measures:

• A larger set of ‘approved’ exchange traded currency derivatives should be allowed.At present, the only currencies that are traded on exchanges are USD, EUR, JPYand GBP. From a trade perspective, the Chinese Renminbi, Swiss Franc, Singaporedollar and the Indonesian Rupiah are significant currencies and trading on thosecurrencies should be allowed. Implied-volatility derivatives are an extremelyuseful tool for managing volatility in currency markets. Since India’s trade ismostly in USD and the INR-USD futures and options market is liquid, it would bean appropriate time to introduce trading a contract on INR-USD implied volatility.Exchange-traded options and swaps should be permissible alongside futures forall traded currency pairs.146

• The position limits in India on exchanges are small compared to global standards.The limits in SGX are more than 10 times the position limits for market participantsand 4 times for exchange members and AD-I like entities in India. Moreover,these position limits are applicable without documentation requirements to showproof of underlying exposure. It is suggested that regulations should be suitablyamended to enhance position limits and remove documentation requirements.147

• The Committee notes that margin requirements on Indian exchanges are 66% morethan the margins in overseas trading venues like SGX. The margin requirementsshould be reduced to remove barriers to participation in exchange traded currencyderivatives markets. Moreover, foreign investors should be permitted to use theirinvestment in corporate bonds and government securities as collateral to meettheir margin requirements.148

• No restrictions should be imposed on derivative transactions based on the dis-tinction between hedging and speculation. The distinction between speculationand hedging is blurred. Any restriction based on such distinction leads to tradingfrictions in Indian markets and consequently, there is a shift of market participantsfrom onshore to offshore venues. Moreover, it was noted that the present statu-

145See, Ministry of Finance, Budget Speech by Hon’ble Finance Minister, see n. 8.146See, Committee on Financial Sector Reforms, see n. 2; also see, Committee on making Mumbai an

International Financial Centre, Making Mumbai an International Financial Centre, tech. rep., Governmentof India, Feb. 10, 2007.

147See Box 4.2, Committee on making Mumbai an International Financial Centre, see n. 146, for adiscussion of the limitations of the Indian currency derivatives market that has led to a shift in trading inderivatives outside the country.

148See, Committee on Financial Sector Reforms, see n. 2, p. 145; also see, Committee on makingMumbai an International Financial Centre, see n. 146, p. 242.


Table 4.1: Foreign investment in rupee denominated bonds

Instrument Cap (USD bn) Eligible investors Sub-limitsGovernment debt 20 FIIs and QFIs USD 5.5 billion in trea-

sury billsGovernment debt 10 SWFs, Multilateral

Agencies, PensionFunds, Insurance Funds

Corporate debt 51 FIIs and QFIs USD 3.5 billion in Com-mercial papers

Source: RBI

tory law does not distinguish between speculation and hedging through derivativetransactions. Any derivative transaction with a scheduled bank or any other agencyunder the jurisdiction of RBI, is legally valid.149

• Foreign investors should be allowed to participate in the exchange traded currencyderivatives segment to the extent of their Indian rupee exposure in India.150 Thiswill help improve the liquidity of the onshore derivatives market in India.

• Foreign Institutional Investors (FIIs) and FPIs should be given national treat-ment in exchange traded currency derivatives markets to ensure deepening ofhedging markets. This includes commensurate changes in their position limits,documentation requirements, margins and custodian choice.151

4.12.2 Develop local currency denominated bond marketsLocal currency denominated bond markets are an alternative source of debt financingfor the public and private sectors. Unlike ECB, the Indian borrower issuing such bondsis not exposed to any currency risk. Therefore, local currency bond markets can enhancefinancial stability by reducing currency mismatches and lengthening the duration ofdebt.152

In the 2000s, domestic bond markets in emerging economies have grown substan-tially. The outstanding stock of domestic bonds now exceeds USD 6 trillion compared toonly USD 1 trillion in the mid-1990s.153 Studies on emerging economies’ debt reveal adistinct shift from foreign to local currency denominated debt.154 Along with an increasein the size of the local debt markets, there has been a substantial increase in foreignparticipation over the last decade.

However the Indian regulatory framework is characterised by quantitative restrictions

149See section 45V, Reserve Bank of India Act, 1934.150A recent RBI notification allowed Foreign Portfolio Investors (FPIs) to participate in the exchange

traded currency derivatives market through a registered trading member. FPIs can take position in foreigncurrency up to USD 10 million or equivalent per exchange without having to establish existence of anyunderlying exposure. Positions beyond USD 10 million in any exchange will require an underlyingexposure. See, Reserve Bank of India, Risk Management and Inter-bank Dealings: Guidelines relating toparticipation of Foreign Portfolio Investors (FPIs) in the Exchange Traded Currency Derivatives (ETCD)market, June 20, 2014.

151See, Committee on Financial Sector Reforms, see n. 2; also see, Committee on making Mumbai anInternational Financial Centre, see n. 146.

152See, Committee on the Global Financial System, Financial stability and local currency bond markets,tech. rep., Bank for International Settlements, 2007.

153See, Shanaka J. Peiris, Foreign Participation in Emerging Markets’ Local Currency Bond Markets,IMF Working Papers 10/88, International Monetary Fund, 2010.

154See, Committee on the Global Financial System, see n. 152.


on foreign participation in domestic bond markets, resulting in limited investments byforeign investors. Table 4.1 presents the current position on foreign participation in rupeedenominated bonds.155 On January 29, 2014, the investment limit for long term foreigninvestors was raised from USD 5 billion to USD 10 billion without raising the overalllimit of USD 30 billion available for foreign investments in government securities. Thisimplies that the limit available to FIIs and Qualified Foreign Investors (QFIs) has beenreduced from USD 25 billion to USD 20 billion.156 Such complex nature of quantitativerestrictions and frequent changes discourage foreign investors from deepening theirengagement with the Indian bond market.

Previous expert committees have recommended that the norms governing the rupeedenominated bond markets should be liberalised.157 It has been specifically recom-mended that the restrictions on foreign investors’ participation in rupee denominatedbond market should be liberalised.158 A recent study commissioned by the SEBI hasalso recommended removal of quantitative restrictions on foreign holding of Indianrupee denominated debt. The study also presents the logic and rationale for why theserestrictions fail to meet the objectives of economic policy.159

Accordingly, the Committee recommends that quantitative restrictions on foreigninvestment in Indian bond market should be dismantled to encourage its development.

Mr. Padmanabhan is of the opinion that such dismantling of limits will have to bedone in a calibrated manner given the implications on reverse flows and stability aswas evidenced in 2013. He prefers to start with a 3 to 5 years policy stability to giveassurance and ability to plan for foreign investors rather than a big bang dismantling.

4.13 Can the revised framework be implemented right away?The Committee recommends immediate dismantling of the extant regulatory frameworkand implementation of the revised framework.

The Committee recommends that the restrictions on borrower, lender, amount, end-use, maturity, all-in-cost, etc. prescribed in the extant framework must be dismantledright away as these do not serve any economic purpose in today’s environment oraddress any market failure as discussed earlier. However, to mitigate volatility anduncertainty in ECB inflows, the Committee recommends continuation of aggregate “softcap” determined internally by the authorities. If the authorities decide for any reasonthat very high value transactions need approval, the approval process must be objective,time-bound and transparent.

The Committee notes that the development of infrastructure for hedging would takesome time. Unless the market is deep and liquid, the cost of hedging would be high. Insuch circumstance, if 100% hedging is imposed, ECB will be unviable. Therefore, the

155See, Reserve Bank of India, Foreign investment in India by SEBI registered Long term investors inGovernment dated Securities, RBI/2012-13/530 A.P. (DIR Series) Circular No.111, June 12, 2013.

156See, Reserve Bank of India, Foreign investment in India by SEBI registered Long term investors inGovernment dated Securities, RBI/2013-14/473 A.P. (DIR Series) Circular No.99, Jan. 29, 2014.

157See, Working Group on Foreign Investment, see n. 2.158See, Committee on Financial Sector Reforms, see n. 2.159See, Ila Patnaik et al., Foreign investment in the Indian Government bond market, tech. rep., Securities

and Exchange Board of India, 2013.


requirement of hedging should factor in the development of the market. The Committeealso notes that with requirement of hedging for very few end-uses, the borrowers arehedging about 15-20% of the exposure. Besides, many borrowers have natural hedge. Itwould be desirable to prescribe a hedge ratio for all borrowing. The authorities mustdecide the hedge ratio which is uniform across sectors and users, and modify the samekeeping in view the availability of facility for hedging currency exposure, the financingneeds of the firms and the economy and the volatility in global risk tolerance.

This approach will address the concern by making foreign currency borrowing lesssystemically risky by imposing a calibrated hedging requirement160. This would not bevery costly given the fact that many borrowers have natural hedges and some borrowersare already hedging to a certain extent.

This makes the hedge ratio the key lever of the ECB policy. It is, therefore, necessarythat there are systems to implement the hedge ratio. One could be requiring the boardsof borrowing companies to certify once in a year that the company fulfils the hedgingrequirement. In addition, RBI, may directly or through authorised dealers, conductinspection of books of a sample of borrowers to verify the extent of hedging by them. Amodel approach to compute hedging, as prepared by Dr. Ajay Shah, a member of theCommittee, is presented in Box 4.2.

4.14 How to deal with FCCBs?The Committee recommends that the debt component of FCCB should be governed bythe regulatory framework governing ECB and to that extent the recommendations of thisCommittee will apply to FCCB.

To the extent that the debt component of FCCB is governed by the regulatoryframework governing ECB, the recommendations of this Committee should apply toFCCB. A distinguishing feature of FCCBs is that they can be converted into equityaccording to a pre-determined conversion price. The Committee deliberated at length onthe issue of resetting the conversion price of FCCBs. It is of the view that the resettingof conversion price should not be allowed as a general rule. The view was motivated bythe following considerations:

• The terms and conditions of issuance including the conversion price of FCCBsare decided at the time of issuance and disseminated to the market at large. Thesaid information, thus, gets factored in the market price of shares being traded.

• Allowing resetting would be akin to changing the rules of the game mid-waywhich would dilute the existing shareholders. The same could not have beenanticipated beforehand and hence, may not be fair to such investors.

However, the Committee is of the view that resetting of conversion price may bepermitted under exceptional circumstances. In cases of severe macro situations, MOF orRBI may be compelled to consider allowing re-setting. Therefore, it is recommendedthat for financial stability purposes, the MOF, in consultation with SEBI and RBI, mayfor a limited time period allow resetting of conversion price. This should be a generaldecision at a given time for a limited period and may not be company specific. This

160See, Khan, see n. 77.


Box 4.2: Hedging

1. What constitutes exposure. Overall currency exposure of the firm mustbe defined as the sum of exposure on account of US dollar denominatedborrowing, financial derivatives on the US dollar, and the dollar-linkedelements of inputs and outputs.

2. What constitutes an acceptable hedge. The firm must simulate a 25%depreciation of the rupee, and ensure that the decline in its net worth, underthis scenario, does not exceed 25%.

3. Exposure associated with ECB. For USD denominated borrowing, it shallbe assumed that a 25% depreciation leads to a 25% increase in the paymentsto be made. Thus, a $1 billion ECB will induce a loss of $250 million. ECBdenominated in currencies other than the USD are assumed to carry no risk.

4. Exposure associated with financial derivatives on the USD-rupee exchangerate. For the financial derivatives portfolio, the firm must compute thechange in value of the derivatives position between the present position andthe scenario of a 25% depreciation.

5. Exposure associated with the core activities of the firm. For the coreactivities of the firm, quarterly projections will be made for the coming 3years. In each quarter, the firm will identify tradeable inputs (where theprice is judged to be linked to the US dollar exchange rate) and tradeableoutputs (where the price is judged to be closely linked to the US dollarexchange rate). Assume that quantities don’t change, and that the 25%INR/USD depreciation merely generates a 25% change in all these values.Calculate the NPV of the impact.

6. Governance and transparency. The assumptions and the calculations willbe approved by the board and, at each year-end, will be fully disclosed inthe annual report.


exception should apply to cases where conversion price of FCCBs is fixed upfront at thetime of issuance.

The Committee further recommends that in cases where the conversion price ofFCCBs is not fixed at the time of issuance, the conversion shall either be at the marketprice prevailing at the time of conversion or at a price linked to the market price at thetime of conversion. The terms in this regard shall be decided at the time of issuance.

5 — Recommendations

This chapter summarises the learning, principles guiding the recommendations of theCommittee and its recommendations based on the same.

5.1 LearningThe following is the learning from the analysis in the previous chapters:

1. ECB is an important source of capital for Indian firms. The annual inflow of ECBhas been about USD 30 billion in recent years.

2. The extant ECB framework is neither contemporary nor grounded in addressingidentified market failures. It pursues so many objectives simultaneously. Theuse of an instrument to pursue so many objectives has adverse or unintendedconsequences.

3. The ECB framework has become needlessly complex, prescriptive, non-neutral,discretionary and unpredictable. All sectors of the economy do not have equalaccess or full freedom to access ECB. Most of the service sector firms, whichcontribute more than half of GDP, do not have access to ECB.

4. The numerous restrictions on borrowers, lenders, amount, end-uses, maturity,all-in-cost etc. in the extant ECB framework have outlived their utility. Theserestrict freedom of economic agents today without addressing any identifiedmarket failure. The ECB policy elsewhere in the world does not have so manyrestrictions on borrowers, lenders, end-uses, amount, maturity, all-in-cost, etc.

5. ECB is not an unmixed blessing. It exposes the borrower firms to currency risk.When the country has managed exchange rate system, firms undertake more ECBexposing them to higher currency risk. This currency risk, if not hedged by a largenumber of firms, has the potential to trigger systemic risk for the financial systemin case of sharp currency fluctuations.

6. The most critical market failure associated with ECB is systemic risk arising fromcurrency exposure of a large number of borrowers. The extant ECB frameworkdoes not address this market failure except to a very limited extent.

66 Recommendations

7. The risk from currency exposure has not culminated into a major crisis so far inIndia. However, the policy needs to embed adequate safeguards.

8. There is a systemic concern that arises form huge fluctuations in ECB flows onaccount of volatility in global risk tolerance. The ECB policy also needs to addressthis concern.

9. The ECB policy elsewhere in the world as well as economic literature is movingtowards a requirement of hedging to address the market failure arising fromcurrency exposure. Measures such as taxation, auction, etc. only limit the inflowof ECB, but do not address the market failure.

10. Hedging is the most convenient and effective means of addressing this. Certaincategories of borrowers are now required to have hedging of a specified percentageof exposure.

11. While some borrowers may have natural hedge, many do not have. Many bor-rowers take excessive currency exposure or do not hedge currency risks becauseeffective facilities for hedging are not available onshore. Or, they believe thatthe possibility of sharp fluctuations in exchange rate is extremely remote or theywould be bailed out.

12. The hedging ratio for ECB/FCCB is low and declined sharply recently reflectingless volatility of exchange rates in the recent past. The firms have hedged about15% of their ECB / FCCB exposure in July-August, 2014. Around 50% of theECB borrowing firms, which constitute over 70% of the ECB amount borrowed ina year, are in need of financial hedging to cover their risks arising out of foreigncurrency borrowing.

13. Hedging reduces the cost advantage the firms may gain from ECB. If the costof hedging is very high, the mandatory requirement of hedging may make ECBprohibitive.

14. Indian markets do not offer adequate facilities for hedging currency risk. Thecurrency derivatives market, not being very deep and liquid, makes the cost ofhedging high. Further, the firms borrowing in foreign currency do not have accessto overseas market for hedging currency exposure.

15. A viable alternative source of financing, the on-shore rupee denominated bondmarket, is not well developed to meet the demands of Indian firms.

16. The challenge is creating a stable ECB environment wherein access to ECB isprovided to as many firms as possible while being prudent and addressing issuesof systemic risk.

5.2 Principles1. The aim of the financial sector policy should be to support real sector firms. The

firms must have access to all possible means of finance at the lowest possible costto be globally competitive.

2. ECB is not an unmixed blessing. It carries with it the risk of currency exposurefor each borrower. When this risk for all borrowers materialises to actual liabilitysimultaneously, it affects systemic stability. It also carries systemic concern arisingfrom huge fluctuations in ECB flows on account of variation in risk tolerance ofglobal investors, not related to fundamentals. Hence, ECB must be allowed and

5.3 Recommendations 67

used with adequate safeguards.3. The ECB framework should be contemporary. The economic agents must have

full freedom to take commercial decisions. This freedom may be curtailed only ifit is absolutely necessary to address any identified market failure.

4. The most critical market failure associated with ECB arises from currency expo-sure of a large number of firms and the consequent systemic risk. Though this hasnot yet become a reality, the State must intervene to address this potential marketfailure.

5. All State interventions must be through only one instrument, namely, regulations.The regulations must state the objectives it endeavours to achieve and it should notbe more than required. It must be made following the standard governance princi-ples such as consultation with the stakeholders. To the extent possible, it must notpursue many objectives simultaneously to avoid unintended consequences.

6. The regulations needs to be principle based to the extent possible rather thanprescriptive. It must be simple and its compliance monitorable. Its implementationmust be transparent and non-discretionary.

7. The regulations must provide the same level playing field to all similarly situatedeconomic agents. It must be neutral across sectors, and participants in a sector.

8. The regulations must prescribe uniform norms such as hedging and the firms mustcomply with the norms while undertaking the transactions. The norms shouldbe reasonable and must have nexus with the purpose. No approval should benecessary for undertaking any transaction.

9. The implementation of the norms must be calibrated in tune with preparedness ofthe ecosystem and of the participants to adopt the same. The ecosystem must beconducive to implement the norms.

10. The ECB regulations must take the exchange rate policy as given even though thelatter has ample scope for reforms.

5.3 RecommendationsThe firms undertaking ECB and not having natural hedge may not hedge their currencyexposure or may take excessive risk either because of moral hazard (they believe thatthe State would prevent large exchange rate fluctuations or bail them out) or becauseof incomplete markets (they do not have cost effective options for hedging currencyexposure). If a large number of firms do not hedge their currency exposure, there canbe a correlated market failure of numerous firms when a large exchange rate movementtakes place. This correlated failure can impose externalities which need to be addressed,along with risk tolerance of global investors which may cause huge fluctuations in ECBflows. Accordingly, the Committee recommends as under:

1. The restrictions on borrowers, lenders, end-uses, amount, maturity, all-in-costceiling, etc. were product of the time and have outlived their utility. These mustbe removed as these do not address now the identified market failure associatedwith ECB, that is, systemic risk arising from currency exposure and global risktolerance.

2. The ECB may be accessed by any firm for any end use. The negative list underthe FDI policy should be the negative list for ECB.

68 Recommendations

3. The ECB may be obtained from any lender who is from a FATF compliantjurisdiction and who has no Indian interests. This implies that domestic Indianbanks, along with their overseas branches and subsidiaries of banks incorporatedin India, should not be allowed to extend ECB, including guarantee.

4. There should be no restriction on the amount that a firm can borrow. It should belinked to its commitment to hedge the currency exposure emanating from ECB.

5. Irrespective of the nature and purpose of ECB, every borrower must hedge aspecified percentage of its currency exposure. Such percentage must be uniformacross sectors or borrowers.

6. Every firm wishing to access ECB must demonstrate hedging of currency expo-sure either through natural hedge or commitment to hedge through derivativestransactions. This means that a borrower may meet the hedge requirement throughnatural hedge and/or through currency derivatives.

7. Since quite a few firms would depend on the derivative market to meet theirhedging requirement, it is necessary to develop the on-shore currency derivativesmarket. Government, RBI and SEBI must make a concerted plan to make thecurrency derivatives market deep and liquid. This would reduce the cost of hedgingand make hedging facilities available so that the requirement of hedging does notcome on the way of ECB. This implies that the hedge ratio must factor in the levelof development of the onshore currency derivatives market.

8. The hedge ratio may be decided by the authorities (MOF-RBI Committee) keepingin view the financing needs of the firms and of the economy, the developmentof onshore currency derivatives markets and any other systemic concern such asvolatility in global risk tolerance. The ratio may be modified by the authoritiesperiodically depending on the exigencies.

9. Since hedging would be the key lever of the ECB policy, RBI should review theextant arrangement for monitoring the hedging compliance by borrowers, andstrengthen it, if required, expeditiously. The Committee recommends that theboard of every borrowing company must be obliged to certify at least once a yearthat the company fulfils the hedging requirement. In addition, RBI, directly orthrough authorised dealers, may undertake inspection of books of a sample ofborrowers to confirm adherence to hedging norms.

10. In case of episodic or structural vulnerabilities, the authorities may modify thehedge ratio to moderate ECB flows. They may however use only one tool, thatis, hedge ratio to moderate ECB inflows and should not use this to pursue otherobjectives.

11. The authorities should prescribe hedging requirement and other related aspects ofECB to address identified market failure only through regulations. Such regulationmust be made in compliance with standard governance principles. It must stateits rationale, something similar to ‘statement of objects and reasons’ appended tobills.

12. The regulations should empower the authorities (MOF-RBI Committee) to pre-scribe and modify the hedge ratio and announce the same through a public instru-ment along with the rationale for the same.

13. There should be no requirement of approval for any ECB transaction.14. ECB policy should be used only to address the market failure inherent in foreign

currency borrowing. It should not be used, to the extent possible, to pursue severalother objectives as has been the practice hitherto.

15. The debt component of FCCB should be governed by the revised ECB framework.Normally, resetting of the conversion price should not be allowed.

16. The Indian domestic rupee debt market is a viable alternative to ECB for financingIndian firms and does not entail any market failure. The policy should aim atremoval of all impediments to the development of the domestic rupee debt market.

In brief, since ECB borrowing firms introduce risk to the system, they need to beobliged to hedge the risk either through natural hedge or financial hedge (in currencyderivative market). However, the cost of hedging should be minimum so that thegains from ECB are not frittered away in derivative transactions and ECB becomesprohibitively costly. The cost of hedging would be reasonable only if there is a deep andliquid well-functioning onshore currency derivatives market. The efforts must be madeto develop such a currency derivatives market and the hedging ratio should factor in thelevel of development of currency derivative market. The hedge ratio would be the keylever of the ECB policy and it could be modified to address systemic concerns, whennecessary.

The new ECB framework may be announced by Government through a press releaseas given at Box 5.1 and may be implemented with effect from April 1, 2015. This shouldapply to all ECB contracted after that date.

Mr. G. Padmanabhan and Mr. S. Ravindran, members of the Committee do not fullyconcur with some of the recommendations and observations made in the report. Thesehave been captured in the relevant paragraphs in the report.

Box 5.1: Revised ECB framework

PRESS INFORMATION BUREAUGOVERNMENT OF INDIADRAFT PRESS RELEASE

New Delhi, ... 2015

Government rationalises the framework relating to External Commercial Borrowing(ECB)

1. Based on a review, Government, in consultation with RBI, has decided to rationalise ECBframework as under:

(a) A company may undertake ECB from (i) any lender who is from a FATF compliantjurisdiction and does not have any Indian interest, (ii) for any end use other thanthose in the negative list under FDI policy, (iii) on the terms it considers appropriate;

(b) There would be no requirement of any approval under the ECB policy from anyauthority for undertaking an ECB or any of the terms of a particular ECB;

(c) A MOF-RBI committee shall determine an uniform hedge ratio across sectors,borrowers and uses, to ameliorate the systemic risk arising from the currency riskexposure from the borrowing. It shall modify the ratio keeping in view the financingneeds of the firms and of the economy, the volatility of global risk tolerance, andthe level of development in the currency derivatives markets.

(d) The hedge ratio shall be xx% of currency exposure arising from ECB contractedafter April 1, 2015. The change in hedge ratio, as and when necessary, shall beannounced through a public instrument along with the rationale for the same.

(e) The hedge ratio shall factor in the natural hedge available to the borrower.(f) Every borrower must demonstrate a plan to fulfil the hedge ratio before borrowing.

Its board of directors must certify at least once a year that the company fulfils thehedging obligation. RBI and/or authorised dealer shall inspect the books of a sampleof borrowers to ensure adherence to hedging norms.

(g) RBI shall prescribe procedural details of availing ECB and its monitoring andconsequences of non-compliance.

(h) As a complementary measure, Government, RBI and SEBI shall take measures todevelop a liquid and deep onshore currency derivatives market and promote rupeedenominated onshore debt market accessible to foreigners. Notwithstanding thesemeasures or the state of development of these markets, the borrowers shall complywith the prescribed hedging norms.

2. RBI shall modify or replace, as may be necessary, the extant ECB framework by March31, 2015 to give effect to the new ECB framework.

3. The ECB framework shall apply to debt component of FCCB.4. The new framework shall come into effect from April 1, 2015 and apply to all ECB

contracted after that date.

(...............)

Joint Secretary toGovernment of India

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Annexure-A1

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Annexure-A2

F.No.9/.r/ 2013-ECBMINISTRY OF FINANCE

Department of Economic Affairs(Capital Markets Division)

North Block, New Delhi,Dated January 1,,2014

ORDER

Subject: Second Phase of the Committee to Review the FCCBs and Ordinary Shares(Through Depository Receipt Mechanism) Scheme 1993.

A committee has been constituted to review the Issue of Foreign Currency

Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism)

Scheme, 1993 vide office order of even number dated September 23, 2013. The

committee submitted its recommendations related to depository receipts. It has been

decided to extend the term of the committee to review the entire framework governing

capital controls and foreign portfolio investment. This would include in particularreview of framework relating to:

(u). External Commercial Borrowings (ECBs) and FCCBs;

(b) Direct listing of Indian companies abroad;

(.). Dual listing of Indian companies;

(d). Residence-based taxation vis-a-vis source based taxation; in respect ofsuch instruments and

("). Relationship between authorities in India and in foreign jurisdictions.

2. The Committee shall have the following composition:

i. Shri M. S. Sahoo, Secretary, ICSI - Chairmanii. Shri G. Padmanabhary Executive Director, RBI - Memberiii. Shri S. Ravindran, Executive Director, SEBI - Memberiv. Prof. Ajuy Shah, NIPFP - Memberv. Shri P. R. Suresh, Consultant, PMEAC - Membervi. Shri Pratik Gupta, Managing Director, Deutsche Bank - Membervii. Shri. Somasekhar Sundaresan, Partner, JSA - Memberviii. Shri. Bobby Pariktu Partner, BMR & Associates - Member

ix. Shri Sanjeev Kaushik, Director (External Markets) - Member Convener

3. The Chairman may co-opt any such additional person (s) as invitees as necessary

for any of the meeting (s) of the Committee.

4. The Committee would meet as frequently as necessary for fulfillment of itsobjectives.

5. The NIPFP-DEA program team will be the secretariat for the Committee and all

expenses related to the Committee's activities will be met from the budget of the

NIPFP-DEA program supplemented as and when necessary.

6. The committee will submit its report within three months from the date of itsconstitution.

7. This issues with the approval of competent authority.

rnt\WKu(

(Manu j.Vettickan)Deputy Director (EM & ECB)

Copy to:

L. All Members of the Committee.

2. Director (RE&C)

3. PPS to Secretary (EA)

4. PS to AS(DEA-K)

5. PS to IS (FM)

[email protected]

Annexure-A3

F.No.9/1/ 2013-ECB MINISTRY OF FINANCE

Department of Economic Affairs (Capital Markets Division)

North Block, New Delhi,Dated January 10, 2014

ORDER

Subject: Second Phase of the Committee to Review the FCCBs and Ordinary Shares (Through Depository Receipt Mechanism) Scheme 1993.

--

A committee has been constituted to review the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 vide office order of even number dated September 23, 2013. The committee submitted its recommendations related to depository receipts. In partial supersession of this Departments’ officer order of even number dated January 1, 2014 it has been decided to extend the term of the committee to review the framework relating to:

(a). External Commercial Borrowings (ECBs) and FCCBs;

(b). Indian Depository Receipts (IDRs)

(c). Direct listing of Indian companies abroad;

(d). Dual listing of Indian companies;

(e). Residence-based taxation vis-a-vis source based taxation; in respect of such instruments and

(f). Relationship between authorities in India and in foreign jurisdictions.

2. The Committee shall have the following composition: i. Shri M. S. Sahoo, Secretary, ICSI -

Chairmanii. Shri.Manoj Joshi, Joint Secretary (FM), DEA -

Member iii. Shri G. Padmanabhan, Executive Director, RBI -

Member

iv. Shri S. Ravindran, Executive Director, SEBI - Member

v. Prof. Ajay Shah, NIPFP - Member vi. Shri P. R. Suresh, Consultant, PMEAC - Membervii. Shri Pratik Gupta, Managing Director, Deutsche Bank -

Memberviii. Shri. Somasekhar Sundaresan, Partner, JSA -

Memberix. Shri. Bobby Parikh, Partner, BMR & Associates -

Memberx. Shri Sanjeev Kaushik, Director (External Markets) - Member

Convener

3. The Chairman may co-opt any such additional person (s) as invitees as necessary for any of the meeting (s) of the Committee.

4. The Committee would meet as frequently as necessary for fulfillment of its objectives.

5. The NIPFP-DEA program team will be the secretariat for the Committee and all expenses related to the Committee’s activities will be met from the budget of the NIPFP-DEA program supplemented as and when necessary.

6. The committee will submit its report within three months from the date of its constitution.

7. This issues with the approval of competent authority.

(Manu J.Vettickan)Deputy Director (EM & ECB)

[email protected]

Copy to:

1. All Members of the Committee. 2. Director (RE&C)3. PPS to Secretary (EA)4. PS to AS(DEA-K)5. PS to JS (FM)

Annexure-A4

TELEGRAMS-ECOFAIRS

: 23092682Fax : 23092271

File No. 9/1/2013-ECB Government of IndiaMinistry of Finance

Department of Economic Affairs(Capital Market Division)

New Delhi the February 5, 2014

ORDER

Subject: Second Phase of the Committee to Review the FCCBs and Ordinary Shares (Through Depository Mechanism) Scheme 1993.

In partial modification of this Department’s order of even no. dated January 10,

2014 on the captioned subject (copy enclosed), Shri Sunil Gupta, Joint Secretary

(TPL II), Department of Revenue is hereby nominated as a member of the Committee.

The other provisions of the order dated January 10, 2014 remain the same.

2. This issues with the approval of Hon’ble Finance Minister.

(Sanjeev Kaushik)Director (EM)Tel. 23095046

To

Shri Sunil Gupta, Joint Secretary (TPL II)Department of Revenue, MoFNorth Block- New Delhi

Copy for information to:

1. All members of the Committee. 2. PSO/PPS to Secy. (EA)3. PPS to Joint Secy. (FS)4. PS to Director (EM)

Annexure-B

Stakeholders who engaged with the Committee

SlNo.

Name Designation Organisation

1. Rabindra Kumar Das Sr. VP, Treasury Adani Group

2. Juvenil Jani CFO Adani Mining Private Ltd.

3. Sanjay Agarwal MD, Global Corporate andInvestment Banking Group

Bank of America

4. Abhishek Garg VP, Corporate Finance andInvestment Banking

Bank of America Merrill Lynch

5. Kaku Nakhate Country Head (India) Bank of America Merrill Lynch

6. Nehal Vora Chief Regulatory Officer BSE Ltd.

7. Abhishek Agarwal VP, Issuer Services - SalesSecurities & Fund Services

Citibank

8. Ashok Swarup Managing Director Citibank

9. Ashwani Khubani VP, Corporate Banking Citibank

10. Bhavna Thakur Director, Head of Equity Citigroup Global Markets IndiaPrivate Ltd.

11. Jeetendra Parmani Capital Markets Organisa-tion

Citigroup Global Markets IndiaPrivate Ltd.

12. Akalpit Gupte Director Compliance Deutsche Bank

13. Ganapathy GR Director, Corporate Finance Deutsche Bank

14. Shailendra Agarwal Director, Corporate Finance Deutsche Bank

15. Jitendra Jain CFO - Corporate Finance GMR Group

16. KamalakaraRao Yechuri

Corporate CFO GMR Group

17. Maneesh Malhotra MD, Head of Debt Finance,India

HSBC

18. Manu J. Vettickan Deputy Director Ministry of Finance

19. Tamanna Sinha Assistant Director Ministry of Finance

20. Hari K. Vice President National Stock Exchange of IndiaLtd.

21. R.N. Kar CGM RBI

22. Anjan Patel AGM SEBI

23. Pranav Variava AM SEBI

24. V.S. Sundaresan CGM SEBI

25. Kanchan Bhave Senior Manager Standard Chartered

26. LS Narayanswami Director Standard Chartered

27. Rajiv Seth Director, Capital Markets Standard Chartered

Dominant part of India’s external debt ... 2.4.1 A comparative analysis ... FDI Foreign Direct Investment.

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